What is a Mutual Fund?

Definition, Basics, Advantages and Types: A Simple Explanation

money tree_mutual funds
What is a mutual fund? Learn the definition and basics. Getty Images

Mutual funds are so simple, we can provide a definition and the basics of investing in this article that will take less than five minutes to read. But the simplicity of investing in mutual funds is not just an attractive feature for beginning investors, the accessibility and easy-to-understand structure of mutual funds make for powerful investing vehicles for all kinds of investors, including the pros.

So without further ado, here's what to know about mutual funds to get started investing:

Mutual Fund Definition

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

Investing in 'Baskets:' A Simple Explanation of Mutual Funds

Now for the simple explanation: Mutual funds can be considered baskets of investments. Each basket holds dozens or hundreds of security types, such as stocks or bonds. Therefore, when an investor buys a mutual fund, they are buying a basket of investment securities. However, it is 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 Apple stock among its portfolio holdings, the mutual fund investor does not directly own Apple stock. Instead, the mutual fund investor owns shares of the mutual fund.

The Advantages of Mutual Funds

Therefore the advantages of mutual funds can be summarized in three words -- simplicity, 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 with fundamental analysis or technical analysis. However, buying shares of a mutual fund enables an investor to own a professionally managed, diverse portfolio with little or no knowledge of investing concepts and strategies.
  • Diversity: All investors, beginners and pros alike, know that putting all of their eggs in 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 be properly diversified. 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.
  • Accessibility: With as little as $1,000 an investor can get started investing with mutual funds. This returns to the simplicity and diversification of mutual funds. Unfortunately, investing concepts and strategies are rarely taught in schools. However, the beginning investor can easily 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 but they can be divided into a few basic types and categories of mutual funds. The two primary types of mutual funds are stock funds and bond funds. Many like to invest in index funds, which often have hundreds of holdings and offer investors the greatest features of mutual funds -- simplicity, diversity and low-cost.

    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 and how to build a portfolio of mutual funds around that core investment.

    Now you're ready to get started investing!

    Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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