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.
