Investing can be difficult for someone who does not have the time, knowledge, or confidence to select individual stocks and bonds.
Mutual funds offer one way to invest in a collection of securities through a single investment.
A mutual fund pools money from many investors and uses that money to build a portfolio of assets such as stocks, bonds, money-market instruments, or other securities. The fund is generally managed according to a stated investment objective.
But mutual funds are not risk-free, and investors should understand how they work before putting money into one.
What Is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from multiple investors.
Instead of buying 20 or 50 individual securities yourself, you can buy shares of a mutual fund that already owns a portfolio of investments.
The value of a mutual fund is generally represented by its net asset value, or NAV.
The NAV is based on the value of the securities held by the fund, after accounting for applicable liabilities and expenses.
How Do Mutual Funds Work?
The process is relatively straightforward.
Investors put money into the fund. The fund manager or management team then invests the pooled money according to the fund’s stated strategy.
For example, a fund might focus on:
- Large-cap stocks
- Small-cap companies
- Government bonds
- Corporate bonds
- International stocks
- Technology companies
- Dividend-paying companies
- A mixture of asset classes
The investor owns shares of the fund rather than directly owning every security in the portfolio.
Why Do People Invest in Mutual Funds?
Diversification
One of the biggest advantages is diversification.
A mutual fund may own securities from many companies and industries. If one company performs badly, its impact may be smaller when it represents only a portion of the entire portfolio.
Diversification does not eliminate investment risk, but it can reduce concentration risk. Investor.gov identifies diversification as one of the common features investors seek when using mutual funds.
Professional Management
Many mutual funds are managed by professional investment advisers.
The manager decides which securities to buy, hold, or sell according to the fund’s investment strategy.
This can be useful for investors who do not want to research and manage every individual security themselves.
Accessibility
Many mutual funds allow investors to start with relatively small amounts.
This can make it easier for investors to gain exposure to a diversified portfolio rather than building one security at a time.
How Do Investors Make Money From Mutual Funds?
There are several potential sources of return.
Rising NAV
If the securities held by the fund increase in value, the fund’s NAV can rise.
An investor may then sell their shares at a higher value than the original purchase price, subject to applicable costs and taxes.
Dividends and Interest
The securities owned by the fund may generate income.
For example, stocks can pay dividends and bonds can generate interest.
The fund may distribute some of this income to shareholders.
Capital Gains Distributions
A fund can also realize capital gains when it sells securities that have increased in value. Those gains may then be distributed to investors according to the fund’s policies and applicable rules.
Investor.gov identifies increased NAV, dividend payments, and capital-gains distributions as potential ways investors can earn money through mutual funds.
What Are the Risks?
Mutual funds are not guaranteed investments.
The securities held by a fund can lose value, which means investors can lose some or all of the money they invested.
Different funds carry different risks.
A stock fund may experience significant price movements, while a bond fund has its own interest-rate, credit, and market risks.
The fund’s investment objective should therefore be considered before investing.
Mutual Fund Fees Matter
Fees are another important consideration.
Funds can have operating expenses, management fees, distribution costs, transaction-related costs, and other charges depending on the structure.
These costs reduce the return investors ultimately receive.
The SEC’s Investor.gov explains that even relatively small differences in fees can have a significant effect on investment results over time.
Consider two hypothetical funds with identical gross investment performance:
| Fund | Annual cost |
| Fund A | 0.25% |
| Fund B | 1.00% |
If everything else were identical, Fund A would leave more of the investment’s return with the investor.
Real-world comparisons are more complicated, but the example shows why fees deserve attention.
Active vs. Passive Mutual Funds
Mutual funds can use different investment approaches.
Actively Managed Funds
An active manager attempts to select investments that will achieve the fund’s objective.
The manager may buy and sell securities based on research, valuation, economic conditions, or other factors.
Index Funds
Index funds attempt to track a particular market index rather than actively selecting investments to outperform it.
Because they generally require less active security selection, some index funds have relatively low costs, although investors should always check the actual expenses rather than assuming every index fund is inexpensive.
What Should You Check Before Investing?
Before investing in a mutual fund, look at:
- Investment objective
- Portfolio holdings
- Historical performance
- Risk level
- Expense ratio
- Other fees
- Fund manager and strategy
- Minimum investment
- Redemption rules
- Tax implications
Past performance should not be treated as a promise of future returns.
The fund’s prospectus and shareholder information can provide important details about its strategy, costs, holdings, and risks.
Who Might Consider Mutual Funds?
Mutual funds can make sense for investors who want diversified exposure without selecting every security individually.
They can also be useful for people who prefer professional management or a structured investment strategy.
However, investors who want complete control over individual holdings may prefer building their own portfolio.
The right choice depends on the investor’s goals, risk tolerance, time horizon, and investment preferences.
Learn More About Mutual Funds
Investors who want a straightforward explanation of the subject can also explore this mutual funds guide for additional information about how mutual funds work and what investors should consider.
Final Thoughts
Mutual funds can simplify investing by allowing many investors to pool their money into a professionally managed portfolio.
Their advantages can include diversification, accessibility, and professional management. Their disadvantages can include investment risk, fees, and limited control over individual securities.
Before investing, read the fund’s documents, understand its strategy and costs, and make sure its risk level fits your financial situation.
