What is a Mutual Fund?

Perhaps you've heard the term "mutual fund" tossed around. Maybe you know that they're the favored investment for many people. But what is a mutual fund?

When people invest in a mutual fund they are pooling their money together to purchase securities, such as stocks, bonds or money market instruments. The fund has a board of directors and employs a portfolio manager to invest the money. An investor's share of gains or losses is proportional to the amount of the fund he owns. For example, if he owns 1% of the fund, he will receive 1% of the returns. Sales charges, annual fees or other charges can be required.

Each fund has an investment objective, and the fund manager chooses securities to achieve that goal. If a fund's objective is to increase the capital, the manager will most likely choose to invest in stocks, whereas for a fund with a stated goal of maximizing income, the manager will tend to stick with bonds.

Most funds also fall into an investment type, which describes the type of securities the fund buys. A list of the most common types and their characteristics follows.

- Sector funds invest in securities from a particular business sector, such as technology.

- Money market funds invest in low-risk, liquid securities such as certificates of deposit and government securities.

- Index funds try to attain the same return as a certain index, such as the Russell 2000 Index, usually by investing in the securities included in that index.

- International funds invest in securities from foreign countries.

- Global Funds invest in both international and domestic securities.

- Balanced Funds invest in both stocks and bonds.

- Growth Funds usually invest only in stocks and have the potential for greater capital gains.

- Growth & Income funds invest primarily in stocks, but also provide income from dividends.

There are several benefits to owning mutual fund shares. Mutual funds are generally comprised of anywhere from sixteen to thousands of different stocks. This spreads the risk out. Even if some stocks are performing badly, chances are others in the fund are doing well. Another plus to mutual fund ownership is that the professional fund manager researches, chooses and watches over the holdings for the investor. Also, a diversified stock portfolio with professional management would be very expensive for an investor to build alone, but both can be had with a relatively small investment in a mutual fund.

Of course, there is no such thing as a risk-free investment, and mutual funds are no exception. Even though a fund has performed well in the past, that is no guarantee that it will continue to do so. Also, funds that seek higher returns usually involve higher risks. An investor should always research a fund carefully before buying.

Unlike stocks, mutual funds are not traded on an exchange, such as the New York Stock Exchange. Some mutual fund shares are sold through financial planners or brokers, while others can be purchased directly from the fund.