What is a mutual fund? The question many potential investors ponder on. A mutual fund is the pooling of money from various investors to invest in stocks, bonds, and money market investment vehicles.
Mutual funds are managed by fund managers or organizations that buy, sell, or hold investment securities ( stocks, bonds, and money market) on behalf of the investors that have collectively invested their money.
What makes Mutual Funds special
A minimal investment from an individual will allow that individual access to various investments that they would have not been able to participate in otherwise. For example, a mutual fund could invest in 75% stock, 15% bonds, and 10% cash.
The 75% investment in stocks will not be an investment in one company but rather an investment in several companies as the picture below depicts.
The picture above displays the top 10 holdings of a hypothetical mutual fund. These holdings are portions of stocks in the companies listed on the left. For example, this fund has a 2.91% investment in Facebook, and an 2.82% investment in Amazon.
Therefore, if you invested in this mutual fund you would be indirectly investing in the companies that the mutual fund invested in at the portion of your investment amount. The picture below represents the allocation of resources for this mutual fund.
This mutual fund is divided across various sectors and industries to reduce complete exposure to investing in one stock. The price of the mutual fund is known as the net asset value or nav. NAV is the total value of the fund divided by number of shares outstanding for that fund.
If the mutual fund was valued at $500,000 and there were 10,000 shares outstanding the NAV would be $50.
If the mutual fund’s NAV is $50, but the fund is currently trading for $55 then the mutual fund is trading at a premium (over valued by the market). However, if the mutual fund is trading for $45 it is trading at a discount ( undervalued by the market).
Why invest in Mutual Funds
Mutual funds allow the investor to diversify their investing across various securities that they would not have been able to do on their own with the same amount of capital. Therefore, when the mutual fund has a gain and loss the individual investor will gain/loss in portion to the amount that they invested and reduce risk in the process.
Many mutual funds will allow an initial investment of $1,000 or a $50 monthly contribution. Investing in mutual funds is a cost-effective way to diversify your portfolio, and not put all your eggs in one basket.
Whereas if you invested $1,000 in buying shares of a single company you would have all your money tied up in one investment. Therefore, exposing yourself to further risk; on the other hand, mutual funds reduce this risk by allowing you the opportunity to invest in multiple companies at the same time with the portion of the money you invested.
Another benefit of Mutual funds is that a professional manager or group of manager are reviewing and researching companies to invest in on the funds behalf. The fund manager(s) receive the fees paid for the fund as compensation. Therefore, the better the mutual fund performs the more compensation the fund manager(s) receives and the high the returns for the investor.