What is a Mutual Fund how do Mutual Funds Work

A mutual fund is a professionally managed pool of investments, funded by people’s money in the hope that the pooled investments will make a profit.

Imagine that you, our two best friends, and I, decided to pool some money together to buy lotto tickets. You contribute $100, they contribute $50 each and I contribute $25. WE WIN! How do we split the money?

Well, first I take out my management fee of 1.25% for having made such a good investment!  (Most funds have management fees which are fairly low) Our remaining profit is split in the same proportions as it was invested! You earn the most, our friends earn equally, and I earn the least.

A typical mutual fund is similar. We contribute to a “fund” which is, in fact, a company that pools assets from investors to make purchases of financial instruments like stocks and bonds.  When we invest in a mutual fund, we are kind if buying “shares” – or units – of the fund, which buys units of other things. 

The fund manager, a professional, researches company portfolios and assess their earnings forecast, among other things. The Manager makes the buying decisions for us.  The manager pools our money with the money of other members in the fund, and buys stocks in various companies or bonds, or a mixture of various other options according to the funds objective.  By pooling with others, we get to own a wide range of investments that would be costly to do on ones own. 

Some of those investment values  go up, some go down depending on many factors including global events like war, an energy crisis, or even the season. But if we are  well-diversified, we can handle market fluctuations.

Each mutual fund has a varying amount of risk associated with it; some are high risk, some are very low.  A bond fund is considered a lower risk investment than an equities fund. But even within the equity funds, some will be investing in small capitalization companies, some in technology, some in precious metals, some in large well-established companies and so on. A fund might also invest in certain geographical locations, like Japan or Latin America. You need a mutual fund that suits your risk-tolerance.

There are fees associated with mutual funds. Most charge a management fee, which is not charged directly to investors but is taken from the fund itself. Others may charge a front-load fee, to purchase. The worst kind of fee, and one which is often hidden, is a back-load fee which means you are charged when you sell or cash out. In my opinion, there is no need to pay these fees with the large number of funds to choose  from. (Most banks do not charge front or back load fees)

A Mutual fund investment is a way to diversify and add balance to your portfolio which basically means not putting all your eggs in one basket. Your choice of fund will depend on the length of time, you have to invest and risk tolerance.