What is a Mutual Fund?

When you want to build a diversified portfolio of assets within a single investment, try using a mutual fund. Mutual funds are a form of investment frequently used by long-term investors. In addition, people will use it as a retirement tool for employer-sponsored retirement plans.

Understanding Mutual Funds

A mutual fund collects money from multiple investors to diversify a portfolio. Typically, investors purchase securities like money market instruments, stocks, bonds, and similar securities.

Professional fund managers typically handle mutual funds and choose what securities to invest in, thus creating a portfolio. Each investor becomes a shareholder and participates in the gains and losses of the fund.

Types of Mutual Funds

Mutual funds can be of the following types.

  • Money market funds. Money market funds comprise government treasury bills and other short-term debt instruments. Although the funds are secure and the principal amount is guaranteed, the investor is unlikely to earn substantial returns.
  • Stock funds. Stock funds invest in equities and stocks. Some equities are classified based on their size as small, medium, or large capital stocks. Others are ranked based on whether they invest in domestic or foreign stocks. A mutual fund will invest in equity stocks that fulfill their investment strategies.
  • Bond funds. Bond funds are fixed-income funds that focus on paying a specific rate of return. Typically, they come in government bonds and other debt instruments. While bond funds tend to pay a higher return, their risk depends on the type of bond.
  • Income funds. Income funds are invested in government and corporate debts until they hit maturity and then payout as a steady income. They are the perfect investment tool for conservative investors and retirees.
  • Index funds. Index funds typically invest in stocks on the major market index, like the Dow Jones Industrial Average (DJIA). The funds require less research from analysts and are great investment options for cost-sensitive investors.
  • Balanced funds. Balanced funds often invest in various asset classes like money market instruments, stocks, and bonds to balance the risk of each asset.
  • Foreign or global funds. While foreign funds invest outside the investor's country, global funds are invested anywhere in the world. The funds, when included in a portfolio, can enhance the diversification of a mutual fund.
  • Specialty funds. Specialty funds aim at specific sectors of the economy, like healthcare, technology, and more. They can be regional, where the investment focuses on a particular geographical area, or targets ethical sectors like solar and wind power.

    • The Investment Process

    To make mutual fund investments, try the following:

    Active vs. Passive Funds

    Before investing in a mutual fund, you must choose between an active or passive investment strategy.

    Actively managed funds try to outperform the market indices and require proper management by professional fund managers. In addition, these funds tend to be more expensive, which can lower the return for investors.

    In comparison, a passive mutual fund attempts to match the market indices. A passive mutual fund will typically have lower fees since they do not require fund managers to outperform the market.

    Consider Your Budget

    When investing in a mutual fund, you must meet the minimum investment amount, ranging from $500 to $3,000. In addition, there are some with a $100 range and a few with a $0 minimum.

    Decide Where to Invest

    Most investors buy mutual funds through online brokerages, which offer a variety across different mutual fund companies. Before deciding on the broker, consider the following factors.

    • Ease of use. Find a brokerage firm with a website and app that is easy to use.
    • Choice of funds. Choose a broker offering different funds without transaction fees.
    • Education tools. Find a broker who provides education and research tools to know more about stocks before investing.

    Understand Mutual Fund Fees

    Before investing, it's best to understand the annual fees when managing and running a mutual fund. This information is crucial as a higher fee can affect your returns.

    Benefits and Limitations of Mutual Funds

    Investing in a mutual fund can have its advantages and drawbacks.

    Benefits

    Investing in a mutual fund can have the following benefits:

    • Ease of use. Mutual funds are highly liquid investments.
    • Diversification. It can offer a diversified investment portfolio that optimizes returns while balancing risks.
    • Professionally managed. Mutual funds are often professionally managed by fund managers who use careful research and trading skills to offer maximum returns.
    • Transparency. Mutual funds are subject to industry regulation, offering fairness and accountability to the investors.

    Drawbacks

    • Cost and fees. Higher fees can reduce the fund's payout.
    • No guarantee. Equity mutual funds can suffer price fluctuations depreciating their value.

    Takeaway

    Mutual funds offer many advantages for investors. However, it's prudent to consider your options, of which there are many, and utilize the help of a professional if you are a novice or need help determining which funds to invest in.

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    Money Management | Building Wealth