These days, most people have mutual funds in their investment accounts. A mutual fund is a pool of many securities, which is run by a professional money-management firm. The fund manager buys and sells large amounts of securities, either, stocks, bonds or some combination, depending on the mission of the fund. When you purchase a mutual fund, you purchase a share of the company, not the individual stocks. Theoretically then, you are buying into a portfolio that is managed by someone who is supposed to be much smarter than you. (Sometimes yes, sometimes no. That's why you have to shop carefully.) Mutual funds are popular for four primary reasons:
- Diversification: Funds allow you to leverage a small amount of money into a larger number of investments than you would ordinarily be able to afford. This can dilute the risk of investing through diversification, an important strategy for success.
- Expertise: Funds allow you to reap the benefits of someone else's investment ability, namely the fund manager, and forego picking individual stocks themselves.
- Pay Yourself First: Ah, the cardinal rule of investing. With mutual funds, you can easily make regular monthly purchases of the fund, by arranging to have the money automatically transferred from your checking or savings account.
- Liquidity. Mutual funds are liquid investments. This means that you can redeem your shares in the market easily, if you find you need to raise cash for any reason.
- Choosing a Fund that is Right for You. There are more than 10,000 mutual funds, with billions of consumer dollars under management. Yet, despite the compelling advertising they're not all going to be right for you. Are you saving for a medium term goal like a new car or addition for your house? In this instance, you'll want a more conservative fund that will grow your investment and minimize market risk. Are you saving for a faraway goal, like a child's education? Then you may want to choose a more aggressive fund, to take advantage of the market's ability to handle long-term ups and downs.
Check out Andrew Tobias' great site Personal Fund for a helpful tool to help you evaluate the true costs of your mutual fund investments.