What Is a Mutual Fund?

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If you’re new to investing, don’t be too surprised if more experienced investors advise you to stick to mutual funds until you get a solid idea of how the stock market works. They’re onto something — mutual funds can be great for beginning investors who don’t want to risk it all on a single stock or spend hours each day researching and selecting companies.

That’s reassuring, of course. But before you dive into this type of investment, it’s important to learn all the basics, including what mutual funds are, how they work and how to know if they’re right for you based on your investment goals. We’ll delve into each of these topics to help give you an idea of whether mutual fund investment is a strategy you want to pursue.

What Are Mutual Funds, and How Do They Work?

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Ever wished you could earn money on investments without having to be too hands-on in managing them? Mutual funds can turn that wish into reality — in a way.

It helps to think of a mutual fund as one big pool of money that different investors all contribute money to. A money manager then takes that whole pool of money and invests it in different assets, usually stocks and bonds. As the investments make money, everyone who put money into the pool profits proportionally to the amount of money they each put in.  

In other words, people who put in larger amounts of money get back larger earnings when the investments in the fund profit. But even those who invest smaller amounts still get a piece of the profits — just a smaller slice. Investing in a mutual fund is sort of like investing in a large, group portfolio that’s assembled and managed by an expert.

Most mutual funds focus on investing in portfolios that contain assets that revolve around a specific theme. For instance, one mutual fund may focus on investing in the best value stocks on the market. Another may focus on building a portfolio of international stocks. Others still revolve exclusively around blue-chip stocks or those that tend to offer high dividends. No matter what type of assets you’re interested in investing in, there’s more than likely a mutual fund out there that focuses on it.

A mutual fund keeps track of how much each investor puts into the fund by dividing the total amount into shares, similar to stocks. The price of a share reflects what’s often referred to as net asset value (NAV) per share, or sometimes NAVPS. Unlike stocks, which constantly change in price throughout the day, NAVs are only updated once at the end of each trading day. If you want to cash out your shares, you can do so at the current per-share price they reflect.

Why Do People Invest in Mutual Funds?

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There are several reasons why mutual funds have remained so popular over time and continue to be an asset of choice for employer-sponsored retirement accounts. Some of these reasons include the following.

Diversification

One of the first things you’ve probably heard as you’ve started to get into investing is that it’s important to diversify your portfolio. But, diversifying can also get expensive if you choose to buy each stock individually. Mutual funds provide an easy way around this, as it’s common for an individual fund to have holdings in over 100 different companies. This makes for a great way to diversify at a relatively low cost and without as much effort.

Increased Access

Some mutual funds also offer access to foreign investments that individual retail investors might not otherwise have the chance to participate in. Additionally, as an individual investor, you can access opportunities that would otherwise only be available to institutional investors when you buy into a mutual fund.

The Expertise Factor

While anyone can invest in the stock market, some people have a lot more time to dedicate to managing their portfolios than others. If you don’t have time to check up on your stocks as often as you should or to do enough research to make sound investments, allowing a professional money manager to take the helm can be a smart way to go.

Overall, the best mutual funds offer a stress-free way to invest, easy access to your money and the peace of mind that comes with knowing it’s in professional hands.

Why Doesn’t Everyone Invest in Mutual Funds?

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So far, mutual funds sound pretty great — so why doesn’t everyone invest in them instead of individual stocks? Just like anything else, mutual funds also come with potential downsides. Some of these include the following:

Commissions and Expenses

As they say, few things in life are free — and mutual fund investments are no exception. Some mutual funds may include fees associated with buying or selling your shares and/or expense ratios. An expense ratio is usually calculated as a percentage of your investment per year, commonly anywhere from 0.25% to 1.5%. Make sure to take a good look at any fees associated with a fund before you invest so they don’t end up cutting into your earnings.

High Minimums

While there are many great funds out there with low or no minimum investment requirements, there are others with prohibitive limits. For instance, the Vanguard S&P Mid-Cap 400 Index Fund Institutional Shares (VSPMX) may look like a great opportunity, but getting in on it will cost you a minimum investment of $5,000,000. If you ever run into this kind of situation, you may want to check to see if the fund is available in ETF form instead; many often are.

No Guarantee and Less Control

As with any investment, there’s no guarantee that the portfolio of the mutual fund you invest in will increase in value. While fund managers do their best to pick assets that are likely to generate returns, their choices are in no way infallible. Additionally, you don’t enjoy the same control as you would if you created your own portfolio. This is why you’ll want to do plenty of research to find a mutual fund that aligns with your risk tolerance and goals.

How Do You Invest in a Mutual Fund?

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One major perk of mutual funds is that they’re generally easy to invest in. If you have an employer-sponsored retirement fund, like a 401(k), the odds are that you’re probably already invested in a few.

When investing on your own, you can purchase mutual fund shares directly from the fund itself, through an online brokerage or as part of a retirement account. The easiest way to invest these days is quite possibly through an online broker, such as Fidelity Investments, TD Ameritrade, Charles Schwab or E-Trade Financial.

Many of these online investing platforms offer easy ways to help narrow down your search, as the sheer number of mutual funds that exist can be a bit overwhelming to beginning investors. You can filter your search to no- or low-cost funds or to those that focus on your preferred risk level and investing strategy. Always make sure that you look over each mutual fund’s breakdown information to get a clear idea of its performance, the top holdings in its portfolio and other vital information like miminums.

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