What is a Mutual Fund?

Mutual funds are a type of investment tool that can be quite profitable and a lower-risk way to invest money. One of the major advantages of a mutual fund is that it allows for a person to make a diversified investment, without having to know a lot about how the stock market works.

For many, however, the concept of a mutual fund seems very foreign, but it is actually a relatively simple financial device.

The Basics

A mutual fund is a collection of money from a pool of investors, which is used to purchase a number of different stocks and bonds. A portion of the net gain of these investments is passed onto the mutual fund investors, in proportion to how much they invested in the mutual fund.

As stated above diversification is one of the biggest advantages of a mutual fund, which simply means that instead of investing the money on a single stock, the money is invested on multiple stocks and investment tools. This helps to spread out the money in the mutual fund, helping to mitigate the impact of any single investment going bad.

Diversification is a generally accepted practice in finance, which has been shown to be an effective way of reducing risk. The idea is that since there are many different investments made under a mutual fund, the losses of some will be outweighed by the gains of others. Providing most of the investments are low risk, this means that over a long period of time, there is much less of a risk of the mutual fund loosing money.

Further, since there are many investors, the pool of money used by a mutual fund can rapidly grow and is much more than any single investor could ever hope to invest in. This greatly increase the buying power, as it is not based on a single person, but instead upon the investments of all members of the mutual fund.

Another reason that mutual funds are so popular is that much of the management of the fund is hands off for the individual investor. This is because the fund itself is managed by a one or more mutual fund managers, which means that the individual investor does not need to understand how to purchase stocks. Since the actual trading is done by professionals, the vetting of the individual companies that make up the stock portfolio is not done by the actual mutual fund investors.

Basically, by agreeing to give the mutual fund a cut of your earnings, you are avoiding having to hire a financial manager and are getting one for free.

It is worth noting that some of the professionals that manage mutual funds are actually criminals, with the ponzi scheme set up by Burt Madoff being a great example of what can go wrong with the hands off approach to investing. Of course, this is generally the exception and not the rule.

One of the other main advantages of a mutual fund is that it is usually easy to buy and sell your ownership in the fund, which is referred to as liquidity. This means that there are often few restrictions or obstacles in place tying the individual to the mutual fund.

So Do I Actually Own Anything?

When you invest in a mutual fund, you are considered to own a portion of the fund, which is directly proportional to how much you invest.

For example, in the case of a $100,000 mutual fund, if you had invested $25,000, you would own 25% of the fund. However, just because you technically own the share and even have some voting rights, the actual purchasing decisions are typically made by the Mutual Fund Managers.

Often the name of the mutual fund will help identify what type of stocks or bonds they invest in. For example, Bob's Bionic Bonanza Mutual Fund, is likely mutual fund that invests in Bionic technology.

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