The Definition of a Mutual Fund
Mutual funds are the most popular way for everyday investors to make money because they are simple to understand and easy to buy and sell. Buying shares in a mutual fund is similar to buying shares in a publicly-traded company except for one key distinction: With a mutual fund, you're buying shares in a portfolio of stocks or bonds (or a mix of both) rather than in a single company.
Mutual Fund Basics
In the simplest terms, a mutual fund is like a basket of investments. Each basket holds certain stocks, bonds, or a blend of stocks and bonds that are chosen by an investment professional or a team of investment professionals.
A mutual fund has a particular strategy or theme. For example, it might invest in stocks from around the globe or a particular region or country. It might focus on the stocks of companies that pay high dividends or have quickly growing revenues and, maybe but not always, earnings. Its managers might select stocks they believe are undervalued or bonds they believe will be less prone to credit risk.
A mutual fund is an open-end investment company—that is, one that can issue and redeem shares whenever it wants. After you have bought shares in a mutual fund, you can sell them back to the fund—either directly or through a broker—for roughly the shares' net asset value (NAV).
The fund's NAV must be calculated once every trading day, generally after the close of exchanges. It's simply the value of the fund's assets minus the amount of its liabilities. The NAV of a single share is calculated by dividing the fund's NAV by the number of outstanding shares.
Mutual fund investors do not actually own the holdings—the stocks or bonds—that have been purchased by the fund. Rather, they benefit from owning shares of the fund that owns those holdings whenever the values of the holdings increase.
The Advantages of Mutual Funds
Some of the main benefits of mutual funds are simplicity, diversification, versatility, and accessibility.
- Simplicity: Most investors do not have the knowledge, time, or resources to build their own portfolio of individual stocks and bonds from scratch. However, buying shares of mutual funds enables investors to benefit from a professionally managed, diverse portfolio even if they have little or no knowledge of investing concepts and strategies.
- Diversification: All investors, beginners and pros alike, should know that proverbially putting all of their eggs into one basket—keeping all of their money in a single investment—is not wise. That old saying makes the case for investment diversification with mutual funds. To diversify with stocks, an investor might need to buy 20 or more securities. However, some broadly themed mutual funds offer a great deal of diversification. For example, an index fund can give you exposure to all the stocks in a major market benchmark. And a balanced fund enables you to invest in stocks and bonds at the same time.
- 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 stock market, such as health care or financials. Investors can also get exposure to commodities, such as gold and other precious metals or oil and natural gas, by investing in a fund that buys shares in companies that produce those commodities. This versatility can be used to produce further diversification as an investor's portfolio of mutual funds grows.
- Accessibility: Mutual funds are easily purchased through an online brokerage account or directly from the investment company. Although many mutual fund firms require a minimum investment of $1,000, you can start buying mutual fund shares with less. For example, Fidelity has no minimum initial investment, and TIAA waives it's usual $2,500 minimum investment if you set up an automatic share purchase plan, with money taken from your bank account once or twice a month.
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. The two primary types of mutual funds are stock funds and bond funds.
From there, the categories of funds get more specialized. For example, stock funds can be further broken into three subcategories based on market capitalization, the total stock market value of the companies a fund invests in: small-cap, mid-cap, and large-cap. They are then categorized further as either growth, which emphasizes stocks with quickly rising prices based on rapid increases in revenue, market share, or earnings, or value, which emphasizes stocks that are trading at a price below what they're really worth.
Some mutual funds choose to focus on producing income from dividends, cash payments made by companies to their shareholders, rather than seeking gains in stock prices.
Bond funds are primarily categorized as short-term, intermediate-term, or long-term based on the number of years until the bonds mature and investors get their principal back. These funds may also be broken into subcategories according to the issuer of the bonds: corporate bonds, municipal bonds, and U.S. Treasury bonds.
A beginning stock investor might start out with an index fund that seeks to match the return of the S&P 500 Index, which tracks the U.S.-listed companies with the highest market caps.
The Risks of Investing in Mutual Funds
Stocks, bonds, and the mutual funds that invest in them all involve some level of market risk, which is the possibility of a decline in value or even, in a worst-case scenario, the total loss of principal—the amount of your initial investment. Before you begin investing, it's a good idea to determine your risk tolerance and invest accordingly.
If you have a low tolerance for risk, you might want to stick with bond funds. If you can watch dips in the stock market without panicking, you might put most of your money in stock funds.
Take your investment time horizon into consideration when determining what types of funds to purchase. If you won't be retiring for many years, you are often encouraged to put a lot of your money in stock funds. As you get closer to retirement, it may make sense for you to become more financially conservative and shift money out of stocks and into bonds.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
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Investor.gov. "Mutual Funds." Accessed May 8, 2020.
Fidelity Investments. "We're Raising the Bar on Value." Accessed May 8, 2020.
Investor.gov. "Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing." Accessed May 8, 2020.