How Do Mutual Funds Work?

A mutual fund refers to a product offered by a company that pools together the money from investors to form several other investments, or a portfolio. Types of mutual fund investments include bonds, stocks, and money market funds.

Investors buy shares of a fund, which means they pool their money into a pot to own a portion of the fund's investment portfolio. An investment manager manages the mutual fund and buys and sells securities or other investments in order to promote growth of the fund.

Through so-called pooling of funds, any investor can invest his or her money in particular projects and companies in which he or she could not possibly afford to invest in otherwise. Mutual funds also allow an investor to own a small piece of many, many companies while he could not necessarily buy individual shares of all of those companies on his own.

Should You Invest in Mutual Funds?

Mutual funds are often the recommended investment for new or inexperienced investors. Through mutual funds, you can simultaneously invest in many sectors and companies without having large sums of money.  This capacity to invest money in several sectors is referred to as diversification. This reduces an investor’s risk when shelling out money. In reality, any form of investment has its own set of risks involved, but risks are usually much higher if an investor buys just one stock. Say a company goes bankrupt or performs poorly. Some or all of your investments will be lost. 

With mutual funds, only a small amount of money is invested per company. So if a company folds, the losses are just a small percentage of the whole portfolio and investment as opposed to the entire investment.

Step-By-Step Mutual Fund Guide

The following step by step guide can also help you to see how mutual funds work:

• First, an investor purchases mutual fund shares. Investors can respond to advertisements released by mutual fund companies regarding information on their investment plans. Shares can be bought directly from brokers or from the mutual fund company itself.
• The second step involves the pooling of money. All contributions from participating shareholders are pooled together to form the investment capital.
• Third, the pooled money is invested in securities. The investment manager invests the money in several types of securities such as the forex market, stock market, or the features market.
• Lastly, investors are paid their profits periodically. Investors, as shareholders, are provided with regular reports regarding the investment’s performance. They can also be paid profit dividends periodically depending on the terms.

Advantages

Mutual funds have three major advantages:

1. Investing in a mutual fund involves less worrying on the part of the investor. In mutual funds, a trained professional manager will do the money management for you. It’s almost a hands-off, no strings attached type of investment.
2. Investors can invest a smaller amount. Depending on the fund, an investor may be able to contribute just $1,000 and still have a diversified portfolio because all contributions are pooled in together, along with the money from other investors, which will be invested as one.
3. As compared to stocks, the price of a mutual fund does not usually fluctuate abruptly. It uses the Net Asset Value, or NAV, which calculates the fund’s new price once a day.

Types of Mutual Funds

There are three major types of investment funds you may want to consider:

• An equity fund consists of investments coming from common stock. It can be riskier than other types of investments; but, with higher risk comes opportunities to earn more profit.
• Second, a fixed-income fund consists of corporate and government securities that provides investors with fixed returns with relatively lower risk.
• Third, a balanced fund combines bonds and stocks and the investments are pooled in together. It may have low risks but lower risks mean lower returns. It is therefore important for investors to first study how much risk they are willing to accept before making any type of investment.

For those considering investing in mutual funds, it is important to look into the history of the fund in terms of diversification and overall performance. Research must be done and the level of risk you are willing to take must be considered. Choosing a mutual fund also depends on your gut-feeling and confidence in the investment.