A mutual fund is a company that is created for one purpose -- to own investments. When you buy shares in a mutual fund, you're effectively buying a portion of the fund's entire investment portfolio. Investors like mutual funds, which are also known as open-end funds, because they combine professional management and diversification.
When you own a share of stock, you own a small piece of that company. When you own a share of a mutual fund, you own a small piece of a company that owns lots of small pieces of other companies. While it's possible to build a diversified portfolio on your own by strategically choosing stocks, when you own mutual funds, the diversification is built in. Diversification is desirable because it spreads out your risk -- instead of losing all of your money if one company does badly, in a mutual fund you only lose a little bit since other companies balance it out.
If you build a large portfolio of stocks, you can create your own diversification. On the other hand, you've also created the responsibility to manage those stocks. As a part of managing your portfolio, you may end up reading reports from the companies, tracking their competition, listening to conference calls and reading third-party research. Mutual fund managers, on the other hands, do all of this for you. Even if they can't do a better job than you, their work can save you a great deal of time and effort.
Shares in many mutual funds are as easy to buy and sell as shares of individual stocks while shares in exchange-traded funds, which are related to mutual funds, trade on stock exchanges just like stocks. This lets you transition between funds relatively easily. However, remember that if you hold your mutual funds in a taxable account, you will have to pay tax on any transfers.
If you'd like to take a more active role in your portfolio than simply buying a mutual fund and letting it sit, you can also use mutual funds to actively manage your investments. For example, if you decide that you're optimistic about the automobile industry, you don't have to choose which auto manufacturer's stock is the best one. You can, instead, buy a mutual fund that only invests in automakers. By doing this, you can build a portfolio that is both specific and diversified.
3 Ways to Gain
Many mutual funds offer three different types of return. Those that hold investments that pay dividends periodically send out dividend checks consisting of what they collected. When a mutual fund sells assets that it owns for a profit, it also sends out distributions of those capital gains. Finally, its share price, usually referred to as its net asset value, can also go up when its holdings' values increase.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.