A mutual fund is a collective investment that pools together the money of a large number of
investors to purchase a variety of securities, like stocks or bonds.
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 can provide diversification,
most are managed by financial professionals, and they offer
investors a wide variety of investment types. To see these benefits in action, let's walk
through an example of how a mutual fund works. Suppose there's an investor who wants to invest
some of their retirement portfolio in the stock market, but they don't have time to
analyze individual stocks and create a diversified stock portfolio. Instead,
they decide that they'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 them? To find the right one, the investor uses online
tools, such as mutual fund searches and ratings given by independent,
third-party organizations, to find a mutual fund that meets their investing goals.
Once they find a fund that looks like a good fit,
they review the fund's prospectus, which is the official summary and explanation
of how the fund operates. The prospectus provides useful information about the fund,
including its fees and charges, minimum investment amounts, performance history, risks, and more.
After researching the fund and its prospectus, our investor decides
that this fund looks like a good investment. So, they buy the minimum required investment
amount, and purchase 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.
Another potential benefit is professional management. Like many 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 they were hoping for. However, 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 costs 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 has bought into a fund, how might they 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's shares do the same. However, when the fund's assets fall in value,
the fund's shares do the same, which is a risk of owning a mutual fund. Unlike a stock,
the value of a fund's 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. Finally, another benefit of mutual funds is
the variety of investments they make available. Our investor chose a mutual fund that invested
in stocks. However, there's 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 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.
There's a lot to learn about mutual funds and other investments, and we've got the
resources to help you get started. Take a look at more of our investing education.