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Mutual Funds: What Are They?
The Definition
A mutual fund is nothing more than a collection of stocks and/or bonds.
You can think of a mutual fund as a company that brings together a group
of people and invests their money in stocks, bonds, and other securities.
Each investor owns shares, which represent a portion of the holdings of
the fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A
fund pays out nearly all of the income it receives over the year to fund
owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund
has a capital gain. Most funds also pass on these gains to investors in
a distribution.
3) If fund holdings increase in price but are not sold by the fund
manager, the fund's shares increase in price. You can then sell your
mutual fund shares for a profit.
Funds will also usually give you a choice either to receive a check for
distributions or to reinvest the earnings and get more shares.
Advantages of Mutual Funds
• Professional Management - The primary advantage of funds is the
professional management of your money. Investors purchase funds because
they do not have the time or the expertise to manage their own
portfolios. A mutual fund is a relatively inexpensive way for a small
investor to get a full-time manager to make and monitor investments. (For
more reading see Active Management: Is It Working For You?)
• Diversification - By owning shares in a mutual fund instead of owning
individual stocks or bonds, your risk is spread out. The idea behind
diversification is to invest in a large number of assets so that a loss
in any particular investment is minimized by gains in others. In other
words, the more stocks and bonds you own, the less any one of them can
hurt you (think about Enron). Large mutual funds typically own hundreds
of different stocks in many different industries. It wouldn't be
possible for an investor to build this kind of a portfolio with a small
amount of money.
• Economies of Scale - Because a mutual fund buys and sells large
amounts of securities at a time, its transaction costs are lower than
what an individual would pay for securities transactions.
• Liquidity - Just like an individual stock, a mutual fund allows you to
request that your shares be converted into cash at any time.
• Simplicity - Buying a mutual fund is easy! Pretty well any bank has
its own line of mutual funds, and the minimum investment is small. Most
companies also have automatic purchase plans whereby as little as $100
can be invested on a monthly basis.
Disadvantages of Mutual Funds
• Professional Management - Many investors debate whether or not the
professionals are any better than you or I at picking stocks. Management
is by no means infallible, and, even if the fund loses money, the
manager still gets paid.
• Costs - Creating, distributing, and running a mutual fund is an
expensive proposition. Everything from the manager’s salary to the
investors’ statements cost money. Those expenses are passed on to the
investors. Since fees vary widely from fund to fund, failing to pay
attention to the fees can have negative long-term consequences.
Remember, every dollar spend on fees is a dollar that has no opportunity
to grow over time. (Learn how to escape these costs in Stop Paying High
Mutual Fund Fees.)
• Dilution - It's possible to have too much diversification. Because
funds have small holdings in so many different companies, high returns
from a few investments often don't make much difference on the overall
return. Dilution is also the result of a successful fund getting too
big. When money pours into funds that have had strong success, the
manager often has trouble finding a good investment for all the new
money.
Mutual Funds: What Are They
Mutual Funds: Different Types Of Funds
Mutual Funds: The Costs
Mutual Funds: Picking A Mutual Fund
Mutual Funds: How To Read A Mutual Fund Table
Mutual Funds: Evaluating Performance
Mutual Funds: Conclusion
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