What is Mutual Fund?
A Mutual Fund is an investment vehicle that enables individuals to pool their resources to gain access to a range of securities, managed by professional portfolio managers. These managers decide what to buy and sell within the portfolio to meet the fund’s stated investment objectives. Whether it's targeting growth, income, or a combination of both, each mutual fund has specific goals outlined in its prospectus.
Consumers typically encounter mutual funds when considering options for retirement accounts like 401(k)s and IRAs, or when exploring individual investments. Mutual funds are popular because they offer diversification, spreading risk across multiple assets, which can help mitigate the impact of a poor-performing stock or bond on the overall portfolio.
How Mutual Fund works
When you invest in a Mutual Fund, you purchase shares of the fund, not the actual securities. Suppose a mutual fund has $100 million in assets and 10 million shares outstanding. If you invest $100, you'll own 10 shares of the mutual fund, assuming the price, known as Net Asset Value (NAV), is $10 per share.
Let's illustrate with an example. Say the fund owns a diversified mix of stocks like Apple, Microsoft, and several bonds. If the fund’s NAV rises to $12 a share due to the increase in asset value, and you sell your shares, you would now have $120 from your original $100 investment.
| Investment | Initial NAV | Final NAV | Shares Owned | Initial Investment | Final Value |
|---|---|---|---|---|---|
| Mutual Fund | $10 | $12 | 10 | $100 | $120 |
Investment returns
Fund returns come from dividends, interest earnings, and any capital gains from selling securities within the fund. Note that you'll face fees such as management expenses and sometimes sales charges, which can impact the total return of your investment.
Why Mutual Fund matters for your money
Mutual funds are essential for investors looking to diversify without the massive capital typically required for buying dozens of individual stocks or bonds. If you have a savings account yielding 4.5% APY, you may compare that to average mutual fund returns, often higher over the long-term, despite short-term market volatility. Diversified mutual funds can potentially offer higher returns, though with more risk compared to a savings account.
Accessibility
Mutual funds are also significant for inclusion in retirement accounts. They make it possible for an average person to have a diversified portfolio, similar to what institutional investors manage, without needing to be a market expert.
Common mistakes
- Failing to read the mutual fund prospectus, which outlines investment strategies and risks.
- Not considering the impact of fees on overall returns.
- Assuming past performance guarantees future results.
Related concepts
Exchange-Traded Funds (ETFs) are similar to mutual funds but trade like stocks. Index Funds track specific market indexes and are often available as mutual funds. Asset Allocation involves spreading investments across various asset classes to balance risk. Expense Ratio is the annual fee that funds charge to cover management costs. Dividend Reinvestment allows earnings to be reinvested into more shares of the fund, compounding returns.