Mutual Fund Basics

Once you've decided to invest in the stock market, mutual funds are an easy way to own stocks without worrying about choosing individual stocks. As an added bonus, you can find plenty of information on the Internet to help you learn about, study, select, and purchase them.
But what is a mutual fund? It's not complicated. A dictionary definition of a mutual fund might go something like this: a single portfolio of stocks, bonds, and/or cash managed by an investment company on behalf of many investors.

The investment company is responsible for the management of the fund, and it sells shares in the fund to individual investors. When you invest in a mutual fund, you become a part owner of a large investment portfolio, along with all the other shareholders of the fund. When you purchase shares, the fund manager invests your funds, along with the money contributed by the other shareholders.

Every day, the fund manager counts up the value of all the fund's holdings, figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that day. If you want to buy shares, you just send the manager your money, and they will issue new shares for you at the most recent price. This routine is repeated every day on a never-ending basis, which is why mutual funds are sometimes known as "open-end funds."

If the fund manager is doing a good job, the NAV of the fund will usually get bigger -- your shares will be worth more.

Advantages of Mutual Funds

Mutual funds have become popular because they offer 4 advantages:
Diversification. A single mutual fund can hold securities from hundreds or even thousands of issuers, far more than most investors could afford on their own. This diversification sharply reduces the risk of a serious loss due to problems in a particular company or industry.

Professional management. Few investors have the time or expertise to manage their personal investments every day, to efficiently reinvest interest or dividend income, or to investigate the thousands of securities available in the financial markets. They prefer to rely on a mutual fund's investment adviser. With access to extensive research, market information, and skilled securities traders, the adviser decides which securities to buy and sell for the fund.

Liquidity. Shares in a mutual fund can be bought and sold any business day, so investors have easy access to their money. While many individual securities can also be bought and sold readily, others aren't widely traded. In those situations, it could take several days or even longer to build or sell a position.

Convenience. Mutual funds offer services that make investing easier. Fund shares can be bought or sold by mail, telephone, or the Internet, so you can easily move your money from one fund to another as your financial needs change. You can even schedule automatic investments into a fund from your bank account, or you can arrange automatic transfers from a fund to your bank account to meet expenses. Most major fund companies offer extensive recordkeeping services to help you track your transactions, complete your tax returns, and follow your funds' performance.

Liquidity with Mutual Funds

The third principle of mutual fund investing is liquidity. Mutual fund shares may be acquired or liquidated at a moment's notice at the fund's next determined net asset value per share. What is more, there is no direct cost of market impact, wherein buying securities tends to drive prices higher and selling securities tends to push prices lower. Nor is there a charge when shares are liquidated (although in some cases a 1% redemption fee is charged and in other cases a contingent deferred sales load may be assessed).
Owning securities individually, of course, is also apt to provide a reasonable level of liquidity. However, mutual funds can easily be converted into cash at a fraction of the cost you would incur in selling individual stocks or bonds. More, the ability to switch easily among different investment options provides remarkable flexibility in building a diversified portfolio, especially considering the costs involved in exchanging individual securities.