Think of a mutual fund as 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 portfolios 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.