What is a Mutual Fund?

When many people talk about investing in the stock market these days, they use the words "mutual funds" as a collective term. Whether they are actually investing in mutual funds, or in stocks, penny stocks, or bonds, they still use this general term. It is important to actually understand what mutual funds are, and to make an educated decision about whether or not this is the type of investment that you want to make.

Today, more than 80 million people, or half of all households in America, invest in mutual funds! Mutual funds first started as a way for the regular person to get a piece of the market. Rather than spending oodles of time understanding the financial market and making educated decisions, mutual funds allow you to diversify and simplify the process. With this said, they are not always the best decision for everyone and people need to understand exactly what mutual funds are before putting their hard-earned money in this direction.

Mutual Fund Basics

A mutual fund is a collection of stocks or bonds. Every person who invests owns what is called shares. These shares are a portion of the overall holdings of the fund. Certainly, if you invest more shares, you own more of the fund. There are three ways that you can make money with a mutual fund. You may earn money from dividends on the stocks and interest on bonds. Almost all of the income that the fund receives over the year is given out to fund owners through distribution. Next, the fund can end up with a capital gain if it sells securities that have gone up in price. Most funds will also pass this money on to investors through distributions. Finally, if the fund holdings go up in price but aren't sold by the fund manager, then each share increases in price. Under this circumstance, you can sell your shares for a profit. When you are ready to collect your profit, most funds will give you a choice. They will allow you either to receive a check for distributions or to reinvest the money and then get more shares.

Why Use Mutual Funds

Mutual funds are one of the simplest and easiest choices when you want to invest in the stock market. You can purchase a fund for relatively little money, and can find one virtually anywhere, as most banks and many companies have mutual funds that they offer. Mutual funds also allow you to diversify, so that any loses will, hopefully, be minimal. Transaction costs with mutual funds are often lower than what someone would pay for securities transactions.

Warnings about Mutual Funds

As with anything that you do in life, there are precautions to take with mutual funds and disadvantages to them. When you put your trust in someone else to manage your money, you may find that this person isn't really as skilled as you assumed. Sometimes, you may have too much diversification, creating dilution and little return on the investment.

Before jumping into mutual funds, or investing your money at all, it is very important to understand all of your options. Mutual funds are one of these options. Some people swear by them and have made great profits from them, while others prefer to go with stocks or bonds. Learn more about all of your options and become an educated consumer. It is, after all, your money.