What is a Mutual Fund

In an unstable economy, the thought of investing in the stock market is a scary one for many people. However, leaving money in a bank savings account or certificate of deposit (CD) is a wasted opportunity to help your money grow. Mutual funds are much safer than investing in individual stocks, but they usually offer a better rate of return than bank savings accounts. Of course, it should be noted that all investments have an element of risk, including mutual funds.

What is a Mutual Fund?

A mutual fund is an investment company that combines investments in a variety of companies or bonds and sometimes other investment vehicles as well. An open-ended fund sells shares continually and must redeem shares on request, while a closed-ended fund is traded on the stock market. Open-ended funds are more liquid as investments. Mutual funds are formed with different objectives: some focus on capital growth, while others are for obtaining monthly income. Some invest in tax-free investment vehicles such as state, territorial or federal bonds, so the income is exempt from federal and/or state taxes.

The primary objective of investing in a mutual fund is diversity: by splitting up your money among numerous investments, you take on much less risk than investing in one alone. If you put all of your money in ABC Corporation stock and the company goes bankrupt, you lose your investment. However, if you invest in a mutual fund with just a small percentage invested in ABC Corporation, the share price will drop slightly when ABC goes under but all your money will not be lost.

Most people do not have the ability to get the same level of diversification on their own as they do by investing in a mutual fund. In order to further hedge against potential losses, most investors put their money in several different types of mutual funds. Bear in mind, investment in a mutual fund does not guarantee financial growth – mutual funds, like stock certificates, are subject to market fluctuation, and if the market goes lower subsequent to investment, then a redemption is made from a mutual fund account, a financial loss will be realized for the investor. A professional Financial Industry Regulatory Authority (FINRA) registered financial advisor is the best person to help you decide how best to invest your money.

There are other advantages to investing in mutual funds. They are highly liquid, so you can pull your money out at any time. In addition, the minimum required investment is usually lower than investing in stocks, which makes it a more affordable option for small investors. They are also managed by expert portfolio management, who keep just the right mix of investments and cash for the best return.

Here is an analogy to help you understand the mutual fund concept. You want a ham sandwich, but you only have a dollar, which is not enough to buy even a loaf of bread, let alone a sandwich. Besides, you don’t need a whole loaf of bread, you just need two slices. So, you gather up 10 friends, each of whom invests one dollar. You now have enough money to buy a loaf of bread, some ham, a jar of mayonnaise, and some lettuce. All 10 of you can now have ham sandwiches, so you all benefited from putting in your dollar. If you get home from the store and drop the jar of mayonnaise, you still have your bread, ham, and lettuce to show for your investment.

Investing in mutual funds generally does not have the high returns of investing in individual stocks, but the risk and required investment are much lower. Mutual funds can be excellent investment vehicles for most small to median level investors in any economy, and they are particularly attractive in a down economy when many people are averse to taking any, much less a high, risk. Consult a professional FINRA registered financial advisor before making any investment decision.