Understanding Mutual Funds

What is a Mutual Fund?

A mutual fund is a financial tool that combines the assets and capital of multiple investors to invest in a portfolio of stocks, bonds, real estate, and other assets. The purpose of a mutual fund is to provide additional income for investors through steady cash flow. Money managers typically manage mutual funds with the goal of creating profitable gains for investors, in exchange for a percentage of the combined assets. Legally, these managers are obligated to act in the best interests of the group of investors. Since the mutual fund is a pool of investors, profits or losses are divided proportionally among each investor. The more capital an investor allocates to the fund, the more they will either profit or lose within that fund. A mutual fund’s performance is typically based on the changes in the market capitalization of the entire portfolio. If the change is positive, investors gain capital, and if it is negative, investors lose capital. Many beginner and intermediate investors are attracted to mutual funds due to the knowledge and professionalism of money managers. Additionally, a mutual fund made up of various assets, such as stocks, bonds, and cryptocurrencies, is a useful tool for diversifying a portfolio, which helps to mitigate risk for the investor.

Types of Mutual Funds

There are many different types of mutual funds for investors to choose from, each with its own unique characteristics. Most mutual funds fall into one of four major categories:

1. Stock Funds: A stock fund is a mutual fund that invests solely in equities. Equities are capital investments in a company with the expectation that the company’s stock value will increase, generating a profit for the investor. Within this category, there are various subcategories from which investors can choose, such as funds with aggressive or passive investment strategies, and funds that invest in US or foreign markets. Each subcategory carries its own level of risk that investors should consider before investing.
2. Bond Funds: A bond fund is different from a stock fund because it pays a guaranteed return to the investor. These bonds generate interest income that is also paid to the investor at regular intervals, such as every six months. Interest rates greatly influence the value of a bond, as higher rates will reduce the amount of money paid to the investor during each interval, and vice versa for lower rates. Unlike stocks, where the potential for profit is unknown, bonds generally offer a safer investment with more predictable cash flow into an investor’s portfolio.
3. Money Market Funds: A money market fund is similar to a bond fund in that it provides a guaranteed return for the investor. However, it differs in that it primarily invests in US treasury bills, while bonds can be investments in the government, foreign markets, or various corporations. Although returns are not as high as stocks or bonds, money market funds are risk-free and provide a higher return than a typical checking or savings account.
4. Balanced Funds: A balanced mutual fund will contain investments in all types of funds, including stocks, bonds, and money market funds. The purpose of this type of fund is to diversify as much as possible to mitigate risk. By diversifying, the fund can potentially provide a steady return with lower volatility than a single asset class.

Exchange Traded Funds (ETFs)

In summary, mutual funds are a useful financial tool for investors looking to create additional income and diversify their portfolios. There are many different types of mutual funds available, each with its own unique characteristics and risks. Investors should carefully consider their investment goals and risk tolerance before choosing a mutual fund.