A Mutual Fund is a collective investment that
pulls together the money of a large number of investors, to
purchase a variety of securities like
stocks or bonds. When
you purchase a share in a mutual fund, you
have a small stake of all investments included in
that fund. Think
of a mutual fund like a basket of investments. When
you purchase a share in a mutual fund, you
are buying one share of this basket, and
therefore have a stake in one small fraction of all the
investments in that fund. Mutual
funds can potentially benefit investors in
several ways. They
are a way to make a diversified investment. Most
are managed by financial professionals.
And because of the wide variety of mutual funds, they
allow investors to participate in a wide variety of
investment types. Let's
walk through an example of how a mutual fund works. Suppose
there is an investor who wants to
invest some of his retirement portfolio in the stock market, but
he doesn't have time to analyze individual stocks and
create a diversified stock portfolio. Instead,
he decides that he'd rather purchase a mutual fund. This
way the investor can purchase a single investment, which
will be similar to purchasing an
entire portfolio of stocks. But
which mutual fund is right for him? To
find the right one he uses online tools such
as mutual fund searches and ratings given
by independent third-party organizations, to
find a mutual fund that meets his investing goals.
Once he finds a fund that looks like a good fit he
reviews the fund's prospectus, which
is the official summary and explanation of how the
fund operates. The
prospectus provides a variety of
information about the fund, including its fees and charges, minimum
investment amounts, performance history, risks, and
other useful information. After
researching the fund and its prospectus, our
investor decides that this fund looks
like a good investment. So
he buys the minimum required investment amount, and
purchases shares of the mutual fund. By
owning shares, the investor now participates
in the gains and losses of all companies held in
the fund.
A benefit of this is diversification, which
is when an investment or portfolio is spread
across several different investments. Doing
this can help lower risk. For
example, if one company that the fund invests in has
a rough year, the impact on the fund's total assets can
be small. Because
that struggling company is only one fraction of
the fund's total assets. Like
most other mutual funds, the fund the investor chose is
actively managed, meaning it is run
by a fund manager or managers who buy
and sell the fund's assets. Fund
managers aim to provide the biggest returns they can
for investors by using financial analysis, and
professional expertise. While
a talented manager could earn good returns for
the investor's fund, there is no guarantee of success. If
a manager makes choices that don't pay off, our
investor won't earn the returns he was hoping for.
However, even if the fund doesn't perform well the
manager still collects a fee, which
is paid from fund assets, meaning even lower returns. Management
fees aren't the only cost our investor has to pay, either. Besides
transaction fees, the fund may
have a sales load, which is a charge to
either buy or sell shares. Some
funds also charge an additional load if
shares are sold within a specific time frame. Now
that the investor is bought into a fund how
might he make money from it? One
way is through appreciation, which is
when the fund's shares go up in value.
Typically, when the fund's assets rise in value the
fund shares do the same. Unlike
a stock, the value of the fund shares does
not change throughout the trading day. Instead,
the fund's value is calculated and updated when
the market closes. Another
way an investor might make money through
a mutual fund is from a dividend payment, which
is when a mutual fund pays out a
portion of its earnings to shareholders. However,
when the fund's assets fall in value the
fund shares do the same, which is a
risk of owning a mutual fund. One
benefit to mutual funds is the variety of
mutual funds available.
Our
investor chose a mutual fund that invested in stocks. However,
there is a mutual fund for almost every type of
investment. For
example, equity funds buy stocks, fixed
income funds buy bonds, and balanced funds buy both. Some
mutual funds may invest in a whole index, while
some others focus on stocks of a certain country or
market sector. Certain
funds have different objectives as well. Some
may look for riskier stocks in growing industries, while
others will invest in more stable companies.
