What Exactly is a Mutual Fund?
DIVERSIFICATION COMES UP a lot. The more types of stocks or bonds you own, the less any one of them can hurt you by tanking. Depending on just a few investments is always asking for trouble.
Yet building and maintaining a diversified portfolio isn't for everybody. To do it right, you might have to keep an eye on as many as 20 to 60 different stocks and bonds at once. Some people thrive on this sort of thing, but others lack the time, interest or experience to give a complex portfolio the attention it demands. For them, the financial industry invented mutual funds, pools of stocks or bonds that are managed by professional investors.
Funds come in all shapes and sizes and most of them work this way: A sponsor company rounds up money and pays a portfolio manager to buy groups of securities according to a specific investing strategy (but keep in mind that strategy could change and isn't guaranteed). The company then sells shares in the fund to the general public at a price reflecting the value of the pooled securities. Buy a share of the fund, and you own a small percentage of the total portfolio, meaning you participate in any of the fund's investment gains or losses. Depending on the fund, you can own a piece of 20 to 500 different companies for a minimum investment of $1,000 to $5,000 sometimes even less.
You may have to pay a fee for the service, but a good fund offers plenty of advantages. Ideally, the pros have years of experience and are given access to piles of industry and company research. It's also true that, unlike a bank certificate of deposit or an annuity, a mutual fund investment is completely liquid, meaning you can get in or out simply, even if you may not be able to retrieve all of your principal investment. But keep in mind that a mutual fund investment also carries more risk and you may lose some or all of the principal that you invest.
As for diversification, think of this example. In 2001, the one‐time Wall Street darling Enron stock plummeted mercilessly as the company crashed and burned in an accounting fraud scandal. If that was the only stock you owned, you'd have been left out in the cold when the company filed for bankruptcy (the biggest in U.S. history). But if you owned a mutual fund portfolio of 100 stocks, with a small percentage invested in Enron, it would have hardly budged on the news.
Funds, of course, are no panacea. While diversification can buffer them from the tyranny of one errant stock, they're still subject to market risk. If the broad market drops, in other words, your fund will usually sink right along with it. Worse yet, there are plenty of lousy funds out there that charge you a lot in fees, and do badly even when the market does well.
More than half of all equity mutual funds routinely fail to beat the returns of the benchmark S&P 500 index. That's why it's essential to choose your funds wisely and strategically.