Far too often investment writers incorrectly assume that their readers understand what a mutual fund is. Read this article as an absolute starting point for learning about mutual funds. Then we can start tackling the tougher mutual fund subjects in a process that will make you a smarter investor. Getting Started Before I dive into the definition of a mutual fund, it is important that you have a basic understanding of stocks and bonds. There are certainly more variations of each than I will cover here, but I don't want to confuse you, so I will keep it simple. Stocks
Stocks represent shares of ownership in a public company. Examples of public companies include IBM, Microsoft, Ford, Coca-Cola, and General Mills. Stocks are the most common ownership investment traded on the market.
Bonds
Bonds are basically a chance for you to lend your money to the government or a company. You can receive interest and your principle back over predetermined amounts of time. Bonds are the most common lending investment traded on the market.
There are many other types of investments other than stocks and bonds (including annuities, real estate, and precious metals), but the majority of mutual funds invest in stocks and/or bonds.
Mutual Funds A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund.
Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in (you don't have to figure out which stocks or bonds to buy). If you would like to know the history of mutual funds, click here. By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification.
Diversification Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously.
The most basic level of diversification is to buy multiple stocks rather than just one stock. Mutual funds are set up to buy many stocks (even hundreds or thousands). Beyond that, you can diversify even more by purchasing different kinds of stocks, then adding bonds, then international, and so on. It could take you weeks to buy all these investments, but if you purchased a few mutual funds you could be done in a few hours because mutual funds automatically diversify in a predetermined category of investments (i.e. - growth companies, low-grade corporate bonds, international small companies). On the next page, I clearly explain how diversification works using a "Wheel of Fortune" concept. Imagine you have a two wheels in front of you, each with different possible outcomes - kind of like the Wheel of Fortune Game show, only each pie piece represents a different return on your money.
Your task is to choose which wheel you would like to spin and you will have to live with the randomly produced result listed on the wheel.
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One Stock- No Diversification
The first wheel represents purchasing a single stock. If you choose to spin it, there is basically a 50-50 chance that you will either make money or lose money. It is like flipping a coin. And among the winning and losing wheel pieces there is a great range of possible outcomes - from a loss of 50% to a gain of 50%.
The second wheel represents purchasing a mutual fund that holds many stocks. This time there is a better chance that you will make money because there are only two pieces that represent a loss. The range is a bit smaller - from a loss of 11% to a gain of of 35%.
Many Stocks (Mutual Fund)- DiversificationTake a close look at the wheels and think about which wheel you would rather spin. And remember, this is not a game. This is your hard earned cash that you are investing!
Choose between: - Wheel 1: One Stock- No Diversification - Wheel 2: Many Stocks (Mutual Fund)- Diversification
The second wheel should be the obvious choice. By purchasing many stocks you have reduced your risk and increased your chance of a winning spin. As I mentioned earlier, you can go beyond this level of diversification by purchasing other mutual funds with different objectives.
To better understand mutual funds, it is best to look at the different categories of mutual funds. Follow this link to learn about your mutual fund choices: Different Kinds of Mutual Funds.
