An Introduction to the Basics of Mutual Funds

What Every Investor Should Know About Mutual Funds

Stock market data
Stock market data. Getty Images/tovfla/E+

Mutual funds offer a way for a group of investors to effectively pool their money so they can invest in a wider variety of investment vehicles and take advantage of professional money management through the purchase of one mutual fund share. Mutual fund companies essentially collect the money from their investors, or shareholders, and invest that pooled money into individual investment vehicles according to some risk profile, money management philosophy, or financial goal.

The mutual fund then passes along the profits (and losses) of those investments to its shareholders.

What Makes Mutual Funds Good Investment Options

Mutual funds are one of the most highly utilized investment options among average investors and financial professionals alike. But why is investing in a mutual fund a good idea? While some mutual funds are objectively better investment than others (and even others that serve very specific investment needs), what mutual funds grant investors access to is perhaps the most important benefit.

First and foremost, mutual funds grant investors access to a wide variety of investments that they otherwise may not carry in their portfolio as individual securities. Since mutual funds invest in a diverse range of securities and investment options, one mutual fund share actually represents proportionate ownership in each and every investment in the mutual fund's portfolio.

Of most interest to investors is that each share also proportionately represents the profits of those investments as mutual funds are required to pass along profits to their investors by way of mutual fund distributions, which come in several forms. In a mutual fund, the value of your shares goes up and down as the value of the stocks and bonds in the fund rise and fall.

For the average investor to have the same exposure to those investment options and potential profits on their own would be extremely costly both in terms of the actual investment dollars and in terms of time.

Additionally, investing in a mutual fund is generally a cost-effective way to gain access to professional money management. Were an individual investor to try to invest in individual securities and actively manage them the way a mutual fund's manager does, it could very easily become a full-time job (as is for the professional fund managers of the world!). In order to make wise investment decisions when you buy individual stocks and bonds yourself, at the very least you'd have to have the knowledge to do extensive research on various types of businesses in general (automobile, construction, medical) and on specific companies (GE, IBM, Microsoft). This is work that most of us are not interested in, do not have the time for, and, most importantly, are probably not as qualified to do.

But through purchasing shares of a mutual fund, you are also purchasing the money management and investment skills of the fund manager whose job it is to invest and reinvest the mutual fund's capital based on the fund's established goals.

While mutual funds offer these benefits to their investors, it doesn't come for free. 

Mutual Fund Fees Cover Administrative Costs

Each investor is charged a percentage of his or her investment to help cover all the costs of running the mutual fund, including having a professional fund manager as well as researching, buying, and selling stocks. But again, investors can benefit from their collective investments. Mutual fund fees are spread out over all of the investors, so the costs to each individual investor is still much less than it would have been if he or she had purchased the stocks directly and paid a broker or financial advisor to manage the investments. Though many mutual fund options are indeed cost-effective, there are many types of mutual fund fees, from front-load fees to constant-load fees, so it is always best to be aware of the type of fee and how it is calculated before investing in a mutual fund. 

Other Types of Mutual Funds: Index Funds

Today, not all funds are managed by a financial manager. Index funds use a computer program to buy all of the stock in a particular index, such as the Russell 3000 or the S&P 500, regardless of how they're performing. They don't have to do research or try to time the movement in the market to buy or sell at the "right" time. Index fund fees, therefore, are generally much lower than the fees for managed funds, and, therefore, the return on investment is higher.

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