Putting money in investments that can go up in value is one of the best ways to save for retirement, but you should never risk your hard-earned cash unless you understand what you are buying. A mutual fund is a type of professionally managed investment that can rise and fall in value, just like a stock. Mutual funds allow investors to gain exposure to wide variety stocks without actually buying stocks.
How Mutual Funds Work
Mutual fund companies gather a pool of money from investors and use those funds to purchase a basket of underlying assets, like stocks, bonds, precious metals and oil. The value of a mutual fund’s shares go up and down based on the value of its asset holdings. For example, if a mutual fund invests heavily in tech industry stocks and the tech industry performs well, the value of the mutual fund's shares are likely to rise. If share values rise, you can sell them to make a profit.
Types of Mutual Funds
Mutual funds fall into three basic types based on the assets that they hold: stock funds, bond funds and money market funds. Stock funds invest heavily in the stock market, while bond funds purchase corporate bonds and money market funds put money in safe, short-term investments. Stock funds tend to be the most risky but they also offer the biggest potential gains. Money market funds usually produce steady, safe returns, but the returns are modest compared to what you can gain in stock funds. Bond funds are generally more risky than money market funds but they can produce higher returns.
Expenses and Fees
Mutual fund managers don't take you money and invest it for you out of the goodness of their hearts. Mutual funds impose an annual fee on all investors that is automatically deducted from accounts to provide compensation to fund managers. Funds may also charge you fees for buying shares, selling shares or failing to keep investments for minimum holding periods. The annual fee can range anywhere from a small fraction of a percent to a few whole percentage points.
The primary benefit of mutual funds is that they can reduce risk through "diversification." Diversification means buying many different investments to reduce the risk of losing a lot of money on a few bad investments. Since mutual funds buy dozens of underlying investments, they provide a degree of built in diversification. A single stock fund can own over a hundred different stocks, which saves you the hassle and expense of buying a wide range of stocks yourself in an attempt to achieve diversification.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.