What is a Mutual Fund? Basic Concept Defined

In brief, a "Mutual Fund" can be defined as a large pool of money collected and used by a "Mutual Fund Company" to purchase a wide range of investment products (Typically Stocks & Bonds or other financial instruments) on behalf of participants. There are several different families or "Flavors" of funds that employ representatives, agents, or managers to purchase a wide range of securities such as stocks, bonds, options, derivatives, and IPOs for the overall enrichment of, or, unfortunately at times, the detriment of the account. The distinct combinations or investment weightings of the preceding are almost infinite. Some funds will "Side" with the "Financial Markets" and should eventually prosper if the indices rise, and others will "Side" against the markets and potentially yield positive results if the markets fail. When choosing a fund, selective participation depends upon which direction the investor thinks or predicts the markets will go in the long term, UP or DOWN.

It's estimated that the first mutual fund was created in the 1920s, however, this new twist on conventional individual stock and bond ownership didn't enter the consciousness of the mainstream investment community until roughly the late 1970s. The original concept was designed and implemented as an easy way for people who may not be financially savvy, to become engaged and ultimately involved in the fast paced, potentially high reward Stock & Bond Markets. Very little if any knowledge in complex Wall Street activities and strategies are required as long as your patience with, and faith in those who manage the fund is steadfast and unwavering. Depending on which mutual you choose to invest in, the day to day price fluctuations that affect the account balance can painstakingly test the stability of your nerves at times, often to the limit, so it's always a good idea to discuss every aspect with a qualified, highly respected and recommended licensed Financial Advisor prior to making a deposit of hard earned cash. Now let's take a look at the general concept and basics of what a mutual fund is. The following is a short answer to a very long and sometimes complex question, but it should provide a good foundation of understanding from which to build upon.

If you strip away all the bells & whistles and focus on the underlying theme, the basic concept is really not that difficult to understand. The following is how I personally define a Mutual Fund and if you reference other sources I think you'll come up with something very similar.

 

  • A "Mutual Fund" is a large collective pool of money deposited by individual investors or institutions which is used by a Mutual Fund Company to purchase and or sell equity, debt, and other securities on your behalf with the intent to provide the best possible return. -

 

The above definition cuts right through to the basic concept, however certain aspects are a little more complicated especially when you address "Tax Considerations", "Types of Investments", "Strategies" etc.

Photo courtesy of othermore (other)
Photo courtesy of othermore (other)

List of Typical Mutual Fund Investments:

Stocks 
Bonds 
Derivatives 
Small Cap 
Federal ( U.S. Issued ) 
Options 
Mid Cap 
Municipal 
Calls  
Large Cap 
Corporate 
Puts 

 

  • Although many other types of securities can be bought & sold, the above list includes some of the most popular -


Automatic Diversification

One of the main benefits of investing in a Mutual Fund as opposed to individual securities is automatic diversification. At any given time, the same fund can own several different stocks or bonds or combination of the two. 30, 40, 50, or even 100+ distinct issues can and usually are held in a typical fund portfolio.

How does this benefit the participant? The main advantage of diversification is to provide a hedge, which means if one or two or more securities decline in market value, the event should have minimal impact on the overall fund performance due to the fact that other securities within the same family might rise in value resulting in a mitigation or curtailment of total lost value ( Unless of course the major indices experience a more significant "Correction" ). One way to put this in perspective is the following. If you own 100 shares of single stock, what happens if the price declines without a hedge? Your $20 stock is worth $18 and your balance is $200 less than what it was before. In contrast, if we realized the same result in a Mutual Fund, a different stock within the portfolio might go UP from $18 to $20, hence canceling out the overall negative impact of the stock that declined in value if of course both holdings were of equal weighting.

Remember the saying " Don't put all your eggs in one basket? There is no better example of "Not putting all your eggs in one basket" than a Mutual Fund. Most fund managers will never buy and hold one single security, they will always purchase a wide variety or "Diversify".


Money Management

When you invest in a Mutual Fund essentially you're hiring a Money Manager(s) to over see, research, and make important investment decisions on your behalf while acting as agent. The fund may have one or more professionals working day and night in a concerted attempt to implement the best possible strategy which will hopefully yield the highest return. Just think of it this way, 50,000 people toss $1000 each into a wheelbarrow, then a Money Manager pushes it to his/her office and begins to slowly divide the funds into several piles to ultimately purchase a diversified selection of mainly stocks and or bonds. Pretty simple concept, but essentially that is the basic principle, just remove the wheel barrel and replace it with a trust account and there you have it.

There are several additional important considerations but one of the main benefits or advantages of investing in a Mutual Fund, is the convenience and time saving aspects. Merely by making an initial deposit as evidence of participation, you automatically delegate a professional who possesses specific expertise within the industry, to choose from a vast assortment of securities to buy and sell on your behalf, and thereafter, he/she monitors the portfolio 24/7 using state of the art technology. A moderate fee is collected from all participants for this hands on management. In addition, the fund manager may have access to unique timely data which the individual investor may not be privileged to see, which in turn, can lead to more efficient trading to the benefit of all clients. If you're not in the financial or social position to research, buy, and monitor investments in a personal portfolio, hiring a Mutual Fund Manager can be a big time saver.


Final Note From an Investor's Point of View:

Mutual Funds can be an excellent way to participate in stock & bond markets mainly due to the inherent nature of immediate "Diversification". An investment strategy and financial tool which provides you as participant, with an opportunity to own a large basket of securities consisting of several different issues, for considerably less money than would be needed to purchase each individual stock or bond separately on your own.


  • Mutual Funds invest in securities listed on all exchanges including the NYSE, NASDAQ, AMEX, and even "Penny" or "Pink Sheet" issues. The level of risk varies dramatically between funds so pick and choose wisely together with an Advisor. -


If you're interested in a Wall Street type of investment, or purchasing securities which may be entangled in a virtual sea of complexities, but you are not up to speed with financial terms, strategies, or inherent risks associated with this type of venture, a situation which inevitably fosters a sense of hesitancy to embark upon the journey alone, you're certainly not in the minority. The vast majority of novice investors are probably in the same situation, and a mutual fund which essentially does all the work for you, just might be the way to go until you become familiar and acclimated with the incredibly intricate and intimidating world of Stocks & Bonds. But remember, always check with your Financial Advisor before investing <>

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Comments 3 comments

rich_hayles profile image

rich_hayles 5 years ago

Brilliant hub. All of the relevant information you might need to get started under one roof. Highly educational and a good guide for novices.

Thanks very much for your hard work.


Tammy L profile image

Tammy L 5 years ago from Jacksonville, Texas

Excellent hub introducing Mutual Funds to new investors and those interesting in investing. This one even helped me some and I've only been investing for the past few years. Thank you very much. :)


nancynurse profile image

nancynurse 4 years ago from Southeast USA

Great hub. Good to see more information about investing . Thanks for writing.

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