What Are Mutual Funds? A Beginner's Guide

Mutual funds are a great way for all investors, experienced or not, to get into the market. However, to understand how they work, you must first have a thorough understanding of stocks and bonds (read "What are Stocks and Bonds?" for more information). If you've already learned about stocks and bonds, read on!

Mutual funds are nothing more than groups of stocks or bonds. The term "mutual fund" comes from the practice of pooling the money of many investors to buy hundreds of different stocks or bonds that would be unaffordable if each investor tried to buy each stock individually. Because some stocks can cost hundreds of dollars per share, a single investor would need tens of thousands of dollars or more to own even one share of every stock in the market. Keeping track of that many individual stocks would also be a Herculean task. By investing in a mutual fund, investors with only a small amount of money to invest can still own the stocks of hundreds of companies, and instead of having to keep track of hundreds of different stocks, they can simply track a single mutual fund account.

There are thousands of mutual funds out there, and their vast numbers can be overwhelming to beginning investors. Understanding the basic types will help you determine which mutual funds are right for you. There are many types of mutual funds, but they can be easily broken down into two categories - managed (or "actively managed") and unmanaged (often called "index" or "passively managed") funds.

In the case of a managed fund, a fund manager decides (based on his or her opinion of various stocks and the intended focus of the fund) which stocks will be bought and sold to make up the fund. If the fund manager makes great decisions and chooses stocks that do well, the fund will have high returns. However, the risk is that if the manager chooses stocks that perform poorly, the fund also performs poorly. Because these funds require managers (who are paid VERY well), they often charge high fees and have a lot of expenses.

Unmanaged funds are funds in which the underlying stocks are not chosen based on a manager's opinion, but rather are assembled to mirror the makeup of a major market index, like the S&P 500 or the Dow Jones - hence the name "index" funds (if you aren't familiar with the S&P 500 or Dow Jones, read "What is a Market Index?" for more information). Because an index fund simply mirrors a specific sector of the market, it will never outperform that sector of the market, but it will never underperform either, which makes it less risky than an actively managed fund. Also, because they do not require human managers, index funds tend to have very low fees and expenses, which helps to bolster returns.

In addition to being managed or unmanaged, every mutual fund will have a different investment focus, to attract investors with different goals. The focus of the fund will determine which stocks it contains. I will be publishing an article called "What are Asset Classes?" soon, which will help explain the differences between various mutual funds. Be sure to check the series introduction article for links to other articles in the series as soon as they become available.