How Do Mutual Funds Work?

Mutual Funds Basics

How do mutual funds work? A mutual fund can be looked at as a cooperative of investors. A number of people pool their investment money together to purchase stocks, bonds, securities of other investment tools. This fund is then managed by a fund manager who will be an expert in this area.



That is the layman view. In professional speak, they are known as collective investments (because the money is invested as a group). Broadly speaking, collective investments are very similar around the world - known as unit trusts in the UK for example - the fund management firms can adopt similar or identical business models in different countries.

(It is worth pointing out that collective investments are only really known as mutual funds in the United States and Canada.)

By pooling money, an individual investor can invest in companies and projects that may otherwise be to expensive to be involved with. Therefore, they are often an ideal starting point for a new investor. It is possible to invest in a range of companies and sectors with relatively small amounts of money.

This ability to invest in a number of companies is called diversification and helps to reduce the risk to an investor. Essentially, investment in a stock market is always risky. However, the risks are much higher if an investor only holds one stock. If that company ceases to trade, the entire investment could be lost. But, by using a fund, a small amount is actually invested in many companies. This means that if one firm folds, the fund should lose just a small percentage rather than everything.

As might be imagined, this ability to diversify with very small sums of money makes and by paying very low fees mutual funds ideal for investors with limited time, experience or money. These can be great investments for beginners!

Types Of Mutual Funds

Close ended funds. You must hold your shares in the fund for a certain amount of time.

The advantages to a mutual fund is that you are purchasing stocks and shares selected by an expert, you also diversifying your portfolio with minimal effort of you behalf. Transaction cost are also spread among all member of the fund making them much more affordable.

The drawbacks are that it is generally a stock market investment and you are subject to the same conditions as all stock market investments, they are not risk free!

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