In a previous “how money works” article, I tackled pre-need plans as a way to invest our money and make it grow. True, the preneeds have fallen into disrepute on account of a few companies going bankrupt and reneging on its commitments to its client. However, reputable pre-need companies are still around. We simply need to exercise caution. As a rule, in investing, it pays to INVESTigate first.

There is another vehicle we can use to grow our money. This is the pooled funds: mutual funds and/or unit investment trust fund (UITF).

Let us examine what a pooled fund is and how it works.

A mutual fund/UITF is a type of professionally-managed collective investment scheme that pools money from many investors to purchase securities. The mutual fund is managed by a professional investment manager who buys and sells securities for the most effective growth of the fund. As a mutual fund investor, one becomes a "shareholder" of the mutual fund company. When there are profits he earns dividends. When there are losses, his shares will decrease in value. However, through mutual funds, small investors can leverage by having the same gain in percentage of the big investors.

How Does a Pooled Fund Work?

Pooled funds are, by definition, diversified, meaning they are made up a lot of different investments. It is an application of the principle "never put all of your eggs in one basket.” By diversifying, losses are cut and gains are maximized.

Because someone else manages them, one doesn't have to worry about diversifying individual investments himself or doing his own record keeping. That makes it easier to just buy and forget about them.

To better understand how pooled funds work, compare it with a cooperative. Years ago I managed our workers' fund through a cooperative. Every week the members invest a fixed amount. Since they were always looking for loan, the money collected was used to grant them easy loans payable in five weeks. As long as they regularly add to the funds, more and more can avail of loan which has a 4.5% interest per month (the same rate as that of pawnshops). In just one year, the fund gained 25%. All of the workers who invested, whether they took loans or not, got their money back with 25% interest. Of course, the ones who did not borrow got the best rate of return.

Pooled funds function the same way. The only difference is that there is no loan involved. Unlike banking products, pooled funds offer no guaranteed interest, and the good thing about this is that the return can even surpass that of the bank products.

In 2007, a friend invested Php 100,000 into an equity mutual fund. Then the global crisis came. The value of his investment shrunk to half. Heeding my advice, he held on and now his investment has already doubled. What are the lessons from this story? First, during crisis, investment opportunities are everywhere. If I had ready funds that time, I would have invested and quadrupled my money. Second, it is wise to invest by breaking the money down into equal monthly investment. In that way, if the market dips, the investment will not be adversely affected and one can take advantage of bargain prices. This is the principle of Peso cost averaging.

Pooled funds can give high returns but not without some risks involved. There are four major risks to be considered in this kind of investment. These are:

Interest rate risk: This is the possibility for an investment to experience losses due to changes in interest rates. The purchase and sale of a debt instrument like bonds may result in profit or loss because the value of debt instruments change inversely with prevailing interest rates.

Market price risk: This is the possibility for an investment to incur losses due to changes in market prices of securities like bonds and equities.

Liquidity risk: This is the possibility for an investment to experience losses due to the inability to sell or convert assets into cash quickly which may be due to trading in securities with small or few outstanding issues, absence of buyers, limited buy/sell activity or underdeveloped capital market. Sometimes redemption may incur losses for the investor. It must be noted that even government securities, which is the most liquid of fixed income securities, may be subjected to liquidity risk particularly if sizeable volume is involved.

Credit risk/default risk: This is the possibility for an investment to experience losses due to a borrower’s failure to repay principal and interest in a timely manner on instruments such as bonds, loans, or other forms of security which the borrower issued.

By proper financial education, one can minimize or eliminate risk. Oftentimes, risk occurs when a person does not know what he is going into. Investing through the “heard” mentality, banking on the “DAW” theory ("sabi ni ganito daw)" may lead to disastrous outcomes. In investing, there are factors other than risks which must be considered. These are the company, investment goals and time horizon.

Different kinds of funds

Pooled funds fall into three categories:

1. Equity funds are made up of investments of only common stock. These can be riskier (but can earn more money) than other types.
2. Fixed-income funds are made up of government and corporate securities that provide a fixed return and are usually low risk.
3. Balanced funds combine both stocks and bonds in the investment pool and offer moderate to low risk. While low risk may sound good, it is also accompanied by lower rates of return, meaning you risk less, but your investment won't earn as much. You have to decide how much risk you're willing to take on before you invest your money.

Remember to do your research and select a mutual fund that fits the level of risk you are willing to take with your hard-earned cash. Then just sit back and hope for the best!

Photo: “Money” by Philip Taylor, c/o Flickr. Some Rights Reserved