Thursday, July 16, 2009

What is a mutual fund?

I think that one of the average investors' best friend is the mutual fund. So What is it and why is it that good for you?

The mutual fund is a group of investors who pool together their money and with the help of a manager buy a collection of stocks, bonds and other investment instruments. Each investors will then own a share of the collection of investment instruments.

So how do you go about investing in mutual funds? You will how to find a company that manages a mutual fund. You will then buy invest your money in the company and you will be given share in the mutual funds.

For examples if you invest $ 100 dollars in a mutual funds that has a total of $ 1000 invested. It means that you own 10 % of the mutual fund and as a result you will have a right to 10 % of the profit after expenses has been paid.

So how does the mutual fund obtain its profit?

The mutual fund get its profit in three ways:

1. The dividend on stocks, coupon payment on bonds and profit on other investments.

2. The mutual fund can sell investment that has been bought at a cheaper rate and that would result in a capital gain.

This profit is then used to pay expenses and after that the remaining profit is distributed among the members.

Another way you can get money is to buy shares from the mutual fund and then when the mutual fund's value increases you can sell the shares for a profit.

Advantages of mutual funds

Investing in a mutual funds has a lot of advantages.

1. Experience manager

The fund will be managed by a seasoned investor with a lot of experience. Most likely if you are investing in a mutual fund it means that you are inexperienced or you do not have enough time to manage your portfolio. Hence the mutual fund is good for you, the manager will invest your money for you and you just have to sit back and watch you money grow.

2. Diversification

You would remember my post on diversification. It is important that you do not invest in stocks or bonds from one company only. Investing in mutual funds will ensure that you are sufficiently diversified because the mutual fund will buy all sorts of stocks, bonds, and other instruments. Hence by investing in a mutual funds it is as if you own shares, bonds and other instruments in those companies. Hence if one company go under it would have limited effect on the mutual fund.

3. Lower cost

Because mutual funds buy investment instruments for a lot of people the cost of buying these instruments decreases considerably. If for example one person was to buy some shares by himself he would pay lets say $ 4. However if the mutual fund was to buy the shares it would also pay the same fee. It would thus mean that the cost to buy these shares will be distributed among the members of the mutual fund. This cost advantages is a definite advantage if you want to invest small amount of money and you do not want to lose a lot of your money in fees and commissions. Read this article for more details.

3. Money back easily

You would remember from bonds or stocks that it is not easy to get your money back. In the case of bonds you will have to wait for the maturity, trade it in the secondary market at a loss or pay a premium up front that will allow you to redeem you bonds before maturity. For stocks on selling the stocks you will have to pay a fee and if you have a portfolio for each type of stocks sold you will pay a fee. However for the mutual fund you just have to contact the mutual fund and you get your money back. It is as easy to get in or get out.

Disadvantages of Mutual Funds:

1. "Experienced manager"

As you can see we have the same advantage and disadvantage. Why is that? That is because a professional investor is not necessarily a good mutual fund manager. On the one hand when he is an investor he is managing his own money on the other hand when he is a mutual fund manager he is managing your money and he is paid whether there is a profit or a loss as he is only an employee. In this case it is better to invest in a mutual fund where the manager has his own money invested in the fund. It could also happens that the manager may be running a scam as the Bernie Madoff scandal showed. So shop around. I would suggest that if you want to diversify have two three different mutual fund with different companies. You could have a stock fund, a bond fund and a money market fund with three different companies. If one goes under you will not lose everything.

2. Higher Cost

Again it might mean that i am contradicting an advantage but there some mutual funds that have a lot of cost so that it would have been better if you have managed you money yourself. First of all a mutual fund is a business who has to have a profit. The mutual fund need to pay fees and commissions when buying and selling securities, postage and other administrative fees, rent, wages of employees and manager, advertising fees , etc. In some mutual funds these fees may be considerable and as a result can really reduce your earnings. So be careful when choosing your mutual fund.

3. Overdiversification

Since the mutual fund will buy into a lot of companies and a lot of bonds it may happen that you are overdiversified. If you invest in a limited number of securities it is easy to spot one that is a drag on your profit and remove it. However in a large basket of securities it is more difficult to do so and you will have some good investment that will hide some bad investment. Furthermore you may invest in a lot of companies in the same category which is not a good strategy.

So as you can see the mutual fund can be a good investment but it may have some disadvantages if you are not careful.

Please read the next post on the different types of mutual funds.

If you have some questions or want to share your experience with us, please leave a comment.

Introduction to diversification
What is an index fund?
What are the different types of mutual funds?

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