If you have read this site for long, read my book, The Confident Investor, or even followed me on Twitter then you have quickly learned that I don't recommend mutual funds to most investors. I feel that an investor can do better by having 20-40% of the portfolio in Index Funds (or Index ETFs) and then the balance in high quality stocks such as the ones on my Watch List. I further suggest that you build your net worth in those great stocks by using my GOPM methodology (Grow on Other People's Money). It is the easiest and most effective way that I have found at increasing the size of your portfolio.
However, I frequently am asked by new investors about mutual funds and how they work. So I thought a short explanation was relevant. If you are an experienced investor then I am sorry if this article is too basic for you - please pass it along to a new investor that you may be mentoring.
A mutual fund is a professionally-managed pool of money that invests in some combination of stocks, bonds, or cash for the benefit of the mutual fund investors. In a mutual fund, you share the increases or decreases in the value of the fund. You do not officially own a share of the fund, such as in a company, but the distinction is irrelevant for an individual investor.
A mutual fund spreads your investment dollars around better than you might be able to do by yourself. This diversification tends to reduce your risk of losing money as well as making money. Diversification usually results in less sudden changes in value, as when some investments are doing poorly, others may be doing well. The reverse is true as well, when one mutual fund holding is doing well it will be tempered by other poor performers in the fund.
A mutual fund's investment managers are trained to look for the best possible returns that are consistent with the fund's strategies and goals. You can almost take it for granted that your mutual fund investment will provide you with the services of a professional money manager. You are in effect betting that the manager will make competent decisions for your investment dollar. In the majority of cases, he is hired or fired on the basis of the whims of the investment firm for which he works. He is rarely subject to customer reviews. It is very seldom the case that you can vote for him being fired, as you could potentially do with the CEO of one of your companies.
Combining your money with other investors creates collective buying power. As a group, mutual fund investors can buy a wide selection of investments. So, rather than just buy one car manufacturer or one bank, they have the funds to buy into ten companies that are similar. This allows you to take advantage of industry trends without relying of the success of one single company.
The size of a fund can be its downfall if it specializes in just one industry segment. If there are not enough excellent companies, then the manager may have to buy into lower quality companies. This strategy potentially invests in too many sub-par companies. The lowering of standards may lead to reduced returns.
You can learn more about the stock market and, more importantly, how to make money in the stock market by buying my book. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in ebook formats for Nook, Kindle, and iPad.