How Do Mutual Funds Work

How Do Mutual Funds Work

So how do mutual funds work?  Well, mutual funds are a type of communal investment that gathers money together from numerous different investors to purchase stocks, bonds, and other securities on a larger scale than what an individual investor could afford independently.

When you contribute money to a mutual fund, you get a stake in all of the fund’s investments, and your portfolio becomes more diverse and potentially more profitable.

You also get an investment professional who actively manages the fund; a real plus if you don’t have the market experience or wisdom necessary to make accurate investment decisions.

Mutual Fund Shares

One of the first questions you might ask is, “Since mutual funds are a collection of securities instead of a single company, who determines the cost of each mutual fund share?”

The net asset value (NAV) determines the price per share of a mutual fund. The NAV is calculated by taking the total value of securities that the fund owns and dividing it by the number of outstanding shares.

If a mutual fund’s total value is $50 million and there are 2 million shares, then the NAV would be $25. So if you wanted to invest $3,000 into a mutual fund with a NAV of $25, you would own 120 shares of that mutual fund.

Benefits of Mutual Funds

A Diverse Portfolio – Many financial experts will tell you that a person needs at least $100,000 to adequately diversify their portfolio with individual stock purchases. But what if you only have a few thousand dollars to start with?

Investing in a mutual fund is a great way to have a well-diversified stock portfolio with a minimum initial investment because mutual funds are already diverse and they have a low minimum requirement.

You need diversification to limit your potential risk of losing money. A decline in the value of a particular security within a mutual fund is often offset by the strength or increasing value of other securities within that fund.

Managed by Investment Professionals – Mutual funds are managed and supervised by professional investment administrators. The goals of the fund managers are directly related to the investors’ success because the managers are paid based on the performance of the mutual fund.

The fund manager uses his or her market experience, wisdom, and expertise to decide when to buy and sell securities. Because the manager is making decisions for the mutual benefit of the fund, the individual investor doesn’t have the difficult job of trying to time the market.

The resources and research expertise of mutual fund managers far exceed those of the average investor.

Mutual Fund Risk and Diversity

There are always risks associated with every type of investing, and mutual funds are not immune. Mutual funds also have management fees (although minimal) that don’t normally accompany individual stock purchases.

Instead of labeling these items as disadvantages, think of them as necessary information needed to make wise and accurate investment decisions.

Mutual funds can add diversity, stability, convenience, and high quality purchases to any investment portfolio, no matter if you want to spend $1,000 or $1,000,000.

Posted in Investing and tagged .