Far too often investment writers incorrectly assume that their readers understand what a mutual fund is. Read this article as an absolute starting point for learning about mutual funds. Then we can start tackling the tougher mutual fund subjects in a process that will make you a smarter investor.

Getting Started

Before I dive into the definition of a mutual fund, it is important that you have a basic understanding of stocks and bonds. There are certainly more variations of each than I will cover here, but I don't want to confuse you, so I will keep it simple.

Stocks

Stocks represent shares of ownership in a public company. Examples of public companies include IBM, Microsoft, Ford, Coca-Cola, and General Mills. Stocks are the most common ownership investment traded on the market.

Bonds

Bonds are basically a chance for you to lend your money to the government or a company. You can receive interest and your principle back over predetermined amounts of time. Bonds are the most common lending investment traded on the market.

There are many other types of investments other than stocks and bonds (including annuities, real estate, and precious metals), but the majority of mutual funds invest in stocks and/or bonds.

Mutual Funds

A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund.

Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in (you don't have to figure out which stocks or bonds to buy).

By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification.

Diversification

Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously.

The most basic level of diversification is to buy multiple stocks rather than just one stock. Mutual funds are set up to buy many stocks (even hundreds or thousands). Beyond that, you can diversify even more by purchasing different kinds of stocks, then adding bonds, then international, and so on. It could take you weeks to buy all these investments, but if you purchased a few mutual funds you could be done in a few hours because mutual funds automatically diversify in a predetermined category of investments (i.e. - growth companies, low-grade corporate bonds, international small companies).