What Is A Mutual Fund?

Benefits and Risks of this Popular Asset Class

What Is A Mutual Fund?
August 13, 2013

A mutual fund is an investment vehicle comprised of several investors’ pool of assets; money is invested on a collective basis in the likes of cash, bonds, stocks, and other securities-based investments. Such funds are managed in a professional way by a fund manager and his or her team in accordance with a specific mutual fund’s investment objectives detailed in the fund’s prospectus.

However, before examining mutual funds in a little more detail, let’s look at two other common places where you can invest funds: savings accounts and stocks.



Savings Accounts

At the present time, interest rates on savings accounts are very low. While there is no guarantee, this seems unlikely to change in the short term — rates aren’t even keeping up with inflation. In light of this, many people who historically have been unwilling and/or reluctant to risk their capital are now prepared to do so in the hope of achieving a better return than they are presently getting.



Stocks

Depending upon the amount of money that investors have available, they can simply invest their funds directly in specific holdings of stocks. However, the amount of money they have available to invest is relevant.

For instance, if an investor only had, say, $1,000 to invest, that sum of money would not enable him or her to place his or her funds in many different stocks, which is a preferred option, as it spreads the investor’s risk. Also, when stocks are purchased, brokerage charges are incurred; these charges are prohibitive when investing small sums of money in several individual holdings of stocks.



Mutual Funds

One of the appeals of mutual funds is that it is possible to invest as little as a few hundred dollars to as much as several hundred thousand dollars or more in them. As the funds from numerous investors are pooled together, mutual funds often contain many millions of dollars.

For instance, if 1,000 investors were each to invest $1,000 in a mutual fund, the fund would have a value of $1 million and they would each own 0.1% of the fund. The fund manager would then use the money to invest in numerous stocks, often in a variety of countries, thus spreading the risk of the individual investors. The manager would also invest in different sectors such as mining, banking, retail, oil, and gas, thus spreading the risk even further. This is what is referred to as diversification.

It is also possible to invest as little as $100 per month in certain mutual funds instead of, or as well as, investing a lump sum.

Since there are numerous companies offering a range of mutual funds, there are potentially hundreds of mutual funds in which to invest. Some of these funds are designed to produce capital growth, some income, and still others a combination of both capital growth and income.

There are funds with varying degrees of risk as well. For instance, a low-risk mutual fund could include investments in such things as money market funds like government-backed securities and large corporations or bonds. A medium-risk mutual fund could include investments in the stocks of major, well-established companies. A high-risk mutual fund could include investments in the stocks of companies involved in emerging markets like environmentally friendly businesses that are relatively new.

An investor can also invest in more than one mutual fund. For instance, he or she could invest 25% of his/her funds in a low-risk mutual fund, 50% in a medium-risk fund, and 25% in a high-risk fund. This, again, is an example of diversification.

Although money in a mutual fund is not tied up for a specific period of time, it is recommended that you invest in mutual funds for at least five years. The reason for this is that if an investor put in $1,000 and then decided that s/he wanted it back in six month’s time, but three months after making the investment the mutual fund dropped in value by 10%, s/he is less likely to get back what s/he had originally invested since the investment has only three months to recover the loss. However, over a five-year period, there is a greater opportunity for that same investment to have made up the loss and generated a profit.

Of course, because experienced fund managers make investment decisions as to which stocks to buy and sell within a mutual fund on behalf of investors, there are charges for their services and other administration costs. These charges come out of the fund’s value and are usually a percentage of the total value.

If a mutual fund is an option you wish to consider, you can purchase one directly from a fund company or through an insurance company/broker, an investment firm, or your bank. You can also seek advice from an independent financial advisor.

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