If you’ve ever gotten together with friends and pooled the change you had among you to buy some fun food, beverages and maybe some music for that impromptu party, then you know a little something about mutual funds.
Alone, neither you nor your friends had enough money to have pulled it off. But by pooling your fractional dollars, each of you was able to create enough funds to invest in the goal of throwing a party at a price you could afford. You could say that the party was the investment goal. In return, you each became shareholders, owning a piece of the party and receiving dividends or a return on investment calculated as a good time.
Similarly, mutual funds allow people with limited resources to participate as investors in the financial markets. This cost effective investment strategy is used not only by individuals who don’t have enough money to invest on their own but institutions looking for steady returns on retirement and other employee benefit plans they provide.
A Pool of Money
In the financial market place, there are companies whose specialty is handling mutual funds portfolios. These investment managers use a pool of money contributed by shareholders to buy stocks, bonds, money markets and other securities that become a part of a portfolio.
In the party example, the securities would be the food, beverages and music or more accurately, the companies that make each of those products. The securities often are referred to as holdings or assets and all of the holdings in the mutual fund combined are what comprise the portfolio.
In a mutual fund portfolio, the mix of securities generally is diversified, an attractive feature for many conservative or high risk averse investors. Typically, a diversified portfolio lowers the investment risk. You still can lose your money, but the risk of that happening is lower than with aggressive investments such as stocks or commodities.
For example, say the mutual fund you invest in has in its portfolio a spread of companies from the technology, pharmaceuticals and telecommunications sectors. If one of the companies or the entire sector has a really bad year, the impact on your investment would not be as great since you own only a fraction of the companies involved.
When you invest in a mutual fund, you are buying shares of numerous companies that amount to a small percentage of the fund’s portfolio. These shares are a fractional representation of the entire mutual fund’s diversified holdings.
If a few securities in the mutual fund lose value or become worthless, the loss may be offset by other securities that appreciate in value. Further diversification can be achieved by investing in a few different funds which represent different sectors or categories. This way the investor is not stuck with the risks associated with a specific industry or category.
Who’s Watching the Store
Professional money managers oversee the mutual funds portfolio and decide which securities to buy and sell based on the fund’s investment objective. The objective may be a long term or short term growth or low or high risk.
The U.S. Security and Exchange Commission (SEC), the stock market governmental watchdog, provides an example. The price of a share at any time is called the fund’s net asset value, or NAV. If you invest $1,000 in a mutual fund with an NAV of $24.75, you will receive 40.40 shares of that fund. When the value of the portfolio increases, so does the value of your investment. And so it goes, if the value of the fund decreases, your investment value similarly decreases.
With most mutual funds, buying and selling shares, and getting information can be done by telephone, mail, or online. The shareholder generally does not have to get involved in researching companies and buying and selling securities. Still, in order to make the best purchase decision, the investor needs to know what is in the portfolio in order to evaluate whether the fund will meet investment goals and risk needs.
Whether you use a broker or a financial manager, we experts advise investors to always read the prospectus carefully before investing in any mutual fund. Most funds have a minimum initial purchase and some are as low as $1,000. You can buy some funds for as little as $50 per month if you agree to invest a certain dollar amount each month or quarter.
A good way to get involved in mutual funds is to start or join an investment club. It is a great way to get to know how stocks work. An investment club is a mutual fund of sorts itself in that each member contributes a minimal amount each month toward the purchase of securities the individual otherwise could not obtain. Just like the party.
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