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.
There is a lot to learn about mutual funds
and other investment options, and we've got the resources
to help you get started.
Take a look at more of our award-winning investing
education.
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