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Mutual Funds: What Are They, and How Do They Work?

Updated May 24, 2017

You've heard of mutual funds and you've heard that they can be smart investments for almost any investor. But what exactly are mutual funds and how do they work?

Mutual funds are the most popular investment types for the everyday investor. Why? Because they are simple investments to understand and they are easy to use -- in many ways, it's "investing for dummies." In fact, if you're not already one of the millions of shareholders of mutual funds, you'll only need to take about two or three minutes out of your day to read this article and you'll be ready to get started investing.

Furthermore the simplicity of investing in mutual funds is not just an attractive feature for beginning investors; the accessibility, versatility and easy-to-understand structure of mutual funds makes for powerful investing vehicles for all kinds of investors, including the pros, and can be appropriate for a variety of savings and investing objectives, including college and retirement.

So without further ado, here's what to know about mutual funds to get you started investing. And if you're already investing, this can be a good refresher course on this powerful yet simple security type:

Mutual Fund Definition: Investing in "Baskets"

A mutual fund is an investment security that enables investors to pool their money together into one professionally managed investment. Mutual funds can invest in stocks, bonds, cash or a combination of those assets. The underlying security types, called holdings, combine to form one mutual fund, also called a portfolio.

In simpler terms, mutual funds are like baskets.

Each basket holds certain types of stocks, bonds or a blend of stocks and bonds to combine for one mutual fund portfolio. For example, an investor who buys a fund called XYZ International Stock is buying one investment security — the basket — that holds dozens or hundreds of stocks from all around the globe, hence the "international" moniker.

It's also important to understand that the investor does not actually own the underlying securities — the holdings — but rather a representation of those securities; investors own shares of the mutual fund, not shares of the holdings. For example, if a particular mutual fund includes shares of stock in Apple, Inc.

(AAPL) among other portfolio holdings, the mutual fund investor does not directly own Apple stock. Instead, the mutual fund investor owns shares of the mutual fund. However, the investor can still benefit by the appreciation of shares in AAPL.

Since mutual funds can hold hundreds or even thousands of stocks or bonds, they are described as diversified investments. The concept of diversification is similar to the idea of strength in numbers. Diversification helps the investor because it can reduce market risk compared to buying individual securities. 

The Advantages of Mutual Funds

To summarize, the advantages of mutual funds can be described in four words — simplicity, versatility, diversity, and accessibility:

  • Simplicity: Most investors do not have the knowledge, time or resources to build their own portfolio of stocks and bonds. Stock investors often have extensive knowledge of fundamental analysis or technical analysis. However, buying shares of a mutual fund enables an investor to own a professionally managed, diverse portfolio, although the investor may have little or no knowledge of investing concepts and strategies. Mutual funds are professionally managed, which means the investor does not need knowledge of investing in capital markets to be successful with them. 
  • Diversity: All investors, beginners and pros alike, know that putting all of their eggs into one basket is not wise. This speaks to the wisdom of diversification with mutual funds. To diversify with stocks, an investor may need to buy 20 or more securities to reach sufficient diversification. However, many mutual funds offer complete diversification in just one security that can be easily purchased. Therefore, a mutual fund investor can break the eggs-in-one-basket rule with mutual funds, at least when getting started, and then add more mutual funds later to increase diversity in the mutual funds portfolio. For more on this idea, be sure to read our article on how to get started investing with just one mutual fund.
  • Versatility: There are so many types of mutual funds that investors can gain access to almost any segment of the market imaginable. For example, sector funds make it possible for investors to buy into focused areas of the market, such as healthcare, technology, financials, and even social media. Beyond sector funds, investors can also access other asset types, such as gold, oil and other natural resources. This versatility can be used for further diversification as an investor's portfolio grows. Professional money managers often use sector funds for this purpose in building client portfolios.
  • Accessibility: With as little as $100 an investor can get started investing with mutual funds. And the fact that mutual funds hold dozens, hundreds, or even thousands of other securities, an investor can gain access to an entire market of investable securities. For example, an investor buying shares in one of the total stock market index funds, gains exposure to over 3,000 stocks in just one fund. This returns to the simplicity and diversification of mutual funds. Although investing concepts and strategies are rarely taught in schools, the beginning investor can find easy tips about how to buy mutual funds online or in bookstores and get started investing within minutes or just a few hours.

Basic Types of Mutual Funds

There are thousands of mutual funds in the investment universe but they can be divided into a few basic types and categories of funds. The two primary types of mutual funds are stock funds and bond funds. From there, the categories of funds get more specialized and diverse.

For example, stock funds can be further broken into three sub-categories of capitalization — small-cap, mid-cap, and large-cap. They are then categorized further as either growth, value, or growth and income. Stocks can also be classified as international, global or foreign, all of which have similar objectives.

Bond funds are primarily categorized by the duration of the bonds, which are described as short-term, intermediate-term, or long-term. They are then broken into sub-categories of corporate bonds, municipal bonds, and U.S. Treasury bonds.  

Most mutual fund categories can be purchased as index funds, which can be described as passively-managed funds. This means that the portfolio manager does not actively buy and sell securities but rather matches the holdings of a benchmark index, such as the S&P 500 index or the Dow Jones Industrial Average. Beginners often start with one of the best S&P 500 Index funds.

From there, investors can learn more about the various types of mutual funds, such as those mentioned here, and how to build a portfolio of mutual funds around that core investment. Index funds often have hundreds of holdings and offer investors the greatest features of mutual funds — simplicity, diversity and low-cost.

Understanding the Risks of Investing in Mutual Funds

Stocks, bonds, and mutual funds all involve some level of market risk, which is the possibility of fluctuation in value or even the loss of principal (the amount you originally invested).

For example, you could invest $1,000 for 10 years and end up with $950. Although receiving a negative return like this over a 10-year period is extremely rare, it is possible. It is more reasonable to expect an average of return of somewhere between 7 and 10 percent for stock investments, including stock mutual funds, for periods of 10 years or more. However, there are short periods, such as 1 year, where your stock mutual fund can decline in value by as much as 30 to 40 percent. Similarly, you could have gains of more than 50% in one year. 

So whether you're investing in individual stocks or a stock mutual fund, you need to have some reasonable expectations about how the stock market behaves. And more importantly, how you will react in the brief but inevitable extremes? Will you sell your mutual funds if they lose 10% in 3 months? Before you begin investing, it's best to get an idea of your risk tolerance.

Getting Started Investing in Mutual Funds

If you're a beginning investor, all you need to do now is identify your investing objective, which might be college savings or retirement, and choose the best funds for you. If you have less than $3,000 to invest, it's possible that you'll need to begin your portfolio with one mutual fund. If that's the case, be sure to read our article on best mutual funds for beginning investors.

Now you're ready to get started investing! 

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