Grandparents love to tell tall tales about the hardships of the old days. "When I was your age, I walked 12 miles to school every day through knee-deep snow!" You might have heard a story like that from your granddad after you complained about the school bus being five minutes late on a chilly autumn morning. Of course, as a child, you probably tuned out as soon as he was getting started. Any sentence starting with "when I was your age" was a pretty good signal that a sermon was about to begin.
But unless your grandparents had a particular predilection toward finances, you probably didn't hear any tall tales like the following:
- "When I was your age, we didn't have any of these newfangled derivatives, stock options, or foreign currency futures contracts."
- "I used to pay a full-commission broker huge fees each time I wanted to buy 100 shares of stock."
- "You young investors have it easy with your $25 automatic investment plans. Back in the day, you could hardly invest at all without a year's wages up front."
If these words had crossed your grandparents' lips, however, they would have been unlike some of the other things your grandparents told you -- because they would have been a lot closer to the truth.
The magic of the mutual fund
It's easy, for instance, for young investors to take mutual funds for granted. With thousands upon thousands of different funds from which to choose, it's hard to imagine a time when mutual funds didn't dominate the investment scene. Yet even though mutual funds have existed since well before the 1929 stock market crash, they didn't emerge as an increasingly influential force in the financial markets until the bull market of the 1960s and early 1970s.
To understand the full value of the mutual fund, you have to take a look at the alternatives that investors had. Before deregulation in 1975, brokerage firms used a fixed commission schedule that the SEC regulated. As a result, if you wanted to buy even a small number of shares of stock, you had to pay commissions that could amount to hundreds of dollars. Furthermore, most trading in stocks was done in round lots of 100 shares. That meant that if you wanted to make a minimum purchase of blue-chip Dow stocks like 3M (NYSE:MMM) or Alcoa (NYSE:AA), you needed to be prepared to buy several thousand dollars' worth of each stock. Putting together a diversified portfolio of even 10 or 20 stocks could require an investment of more than $100,000.
Now, with the advent of discount brokers, many of these obstacles to investing are much easier to overcome. Buying in so-called "odd lots" of fewer than 100 shares is far easier to accomplish. Some brokers, such as Sharebuilder and FOLIOfn, even allow you to buy fractional shares of stock. However, even the lowest commissions add up when you're trying to build a diversified portfolio.
Instant diversification
Mutual funds have revolutionized the financial markets by opening a wide variety of investments to small investors. Simply by making a small initial investment that in some cases can be as low as $50, you can buy mutual fund shares that represent a minuscule fraction of a share of hundreds or even thousands of different companies. For instance, the Vanguard Extended Market Index Fund (VEXMX) holds shares of more than 3,000 companies, ranging from large companies such as Genentech (NYSE:DNA) and Celgene (NASDAQ:CELG) to much smaller companies such as Cascade Microtech (NASDAQ:CSCD). Its $3,000 minimum means that you will be investing an average of just a dollar in each of those companies, and because the fund owns more in some companies than in others, it's likely that you will own only a few cents' worth of the smaller companies in the fund. Every month, when your $100 investment moves out of your checking account and into the fund, it is deployed penny-by-penny among all of the fund's holdings. Many mutual funds don't charge you any fee at all when you make this investment; you merely pay your share of the fund's overall expenses from the fund's income.
The wide range of mutual funds makes it easy to diversify, too. By using mutual funds that specialize in a particular sector of the market, such as the Fidelity Utility Fund (FIUIX) and the American Century Life Sciences Fund (ALSIX), you can invest in a promising industry without having to guess which particular company in that industry will outperform the others. Similarly, different funds let you focus on big stocks or tiny stocks, U.S. stocks or foreign stocks, or many other types of investments, including bonds, precious metals, real estate, and commodities.
The next big thing?
The financial industry moves ever onward, looking for new innovations. As the traditional mutual fund industry has matured, attention has moved to other ideas. Exchange-traded funds require the use of a broker but give shareholders wider flexibility to trade during a given day and to time transactions taking tax consequences into consideration. Single-stock futures and a growing array of options allow investors to use leverage to magnify their potential profit or loss in an investment. Inevitably, new products that no one has ever seen will appear in the coming years and decades.
By the time that happens, you may be a grandparent. You can then tell your grandchildren tall tales about having to drive to school without an air-car. As for investing stories, however, you'll look back and realize that you had a pretty good deal. Mutual funds made it easy.
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Fool contributor Dan Caplinger can't wait to own his first air-car, but until then, he'll have to rely on his in-laws for good grandchildren stories. He doesn't own any shares of the funds or companies mentioned in this article. 3M is a Motley Fool Inside Value recommendation. The Fool'sdisclosure policyisn't a tall tale at all.
