What is a Mutual Fund?

One of the simplest ways for new investors to begin building a portfolio is to buy shares of a mutual fund. The problem many new investors face is understanding exactly what a mutual fund is and why it makes investing easier.

At its most basic, a mutual fund is simply a pre-selected portfolio of other investments. Mutual funds can be made up of stock investments or even bond investments. There are funds that invest only in certain areas of the economy which are known as "sector" funds. A sector fund might only invest in utilities, or only in technology manufacturers, or only in mining companies. Mutual funds might also only invest in companies of a certain size. Funds that invest in very large companies are known as "large-cap" or "large capitalization" funds, while those that invest in smaller companies are known as "mid-cap" or "small-cap" funds.

Mutual funds are very often established under a charter, and are required to follow that charter in constructing their portfolio. The charter often calls for a fund to limit its ownership of certain kinds of investments. A bond fund, for example, would be prohibited by its charter from investing in stocks, even if stocks would be better investments at the time. Many charters also call for mutual funds to always have a certain amount of their assets invested, meaning that the fund is prohibited from just selling all of its shares and keeping its assets in cash.

A mutual fund that invests in stocks, for example, pools the investments of all of its shareholders, then uses that investment pool to purchase stock in a variety of companies according to its charter. The mutual fund then issues shares to its investors: but not those of the individual stocks. A mutual fund issues shares of the fund itself.

The shares in a mutual fund are given a value which is based on the total value of all the stocks in the fund's portfolio, and each individual share's value is determined by the number of outstanding shares in the fund. This individual share value is known as an NAV or "net asset value." The NAV is the "price" of a mutual fund, and is used to measure the performance of the fund and its investments.

The reason mutual funds are often a good way for people to become accustomed to the market is they are operated by fund managers who make the decisions on which investments to buy and sell. These fund managers are often extraordinarily knowledgeable about investing, and have access to resources and research an individual investor might not, making it possible for an individual investor to sometimes benefit from superior trading decisions without having to manage an entire stock portfolio on their own.

The mutual fund industry has a variety of mechanisms to rate the performance of the thousands of different mutual funds that are available to investors. One of the more well-known services is called "Morningstar" which gives each fund from one to five stars based on how well that fund has performed recently for its investors.