In our last Investing Basics article, we talked about bonds. Today we’ll discuss mutual funds. Later, we’ll look at options, futures, and short-term savings options.
What Is a Mutual Fund?
A mutual fund is simply a portfolio of securities. Multiple investors go in together to provide the money needed to buy those securities. Then a professional fund manager chooses which securities the fund will invest in – often within a set of guidelines called the fund’s “objective”.
Basically, mutual funds provide diversification at a low cost for investors. Many mutual funds own thousands of securities. It would be extremely expensive for an individual to own that many securities on their own. Transaction costs and higher prices (due to buying small quantities) make it impossible for all but the very richest of people to duplicate the massive number of securities in a mutual fund.
When you buy a mutual fund, you’re buying an interest in the fund’s portfolio of securities. If you’re buying directly from the mutual fund company, you’ll pay a price that represents the actual value of the securities in the portfolio. If you buy from other investors, you might pay a higher or lower price than the actual value of the securities in the portfolio.
If the securities in the portfolio provide dividends, capital gains, or interest, the mutual fund company will pass these along to you. However, mutual funds still cost money to maintain and operate. These expenses are covered by the assets in the mutual fund, so your total return will be lowered by these expenses. For this reason, it’s important to choose mutual funds that have low expenses.
What’s in a Mutual Fund?
Mutual funds can hold just about any kind of security you can imagine. There are stock mutual funds, bond mutual funds, and mutual funds that invest in stocks and bonds. There are mutual funds that use options, those that invest in commodities, and even mutual funds that own other mutual funds. It would take several articles to go through all the different types of mutual funds available.
For right now, you don’t need to know about every little detail of every single type of mutual fund available. What you need to remember is that mutual funds can be a cost-effective way for you to diversify your investments across thousands and thousands of securities. And that’s a good thing.
There’s Much More to Learn about Mutual Funds
This is just the tip of the mutual fund iceberg. I haven’t explained net asset value (NAV), expense ratios, loads, turnover, 12b-1 fees, open-end funds, closed-end funds, and so much more. But those are things for the next level. If you want to keep learning about investing, make sure you sign up for free updates to Provident Planning!
