What is a Mutual Fund? A Complete Guide for Beginner Investors

Mutual funds are investment instruments that allow you to pool funds with other investors and then entrust them to professionals for management. What exactly are mutual funds? They are a popular investment solution because they offer important diversification to minimize risk. Additionally, mutual funds can be a good way to start your investment journey, especially since they require a relatively small amount of money to get started.

Understanding the Definition and Concept of Mutual Funds

A mutual fund is an investment instrument that enables a group of investors to combine their capital and entrust it to a professional called a fund manager. The fund manager’s task is to invest the money into various securities, including stocks, bonds, and cash. The main goal of investing in mutual funds is to earn a profit from your investment. This profit can come from interest payments, dividends, or capital gains. Capital gains occur when the value of securities within the mutual fund increases and the fund manager sells them at a higher price.

Main Benefits of Investing Through Mutual Funds

The primary advantage of investing in mutual funds is that they give investors access to a variety of investments that might not be available to them individually. For example, investors with limited funds cannot afford to buy a diversified portfolio of individual stocks and bonds. However, by investing through mutual funds, they can gain exposure to various securities without incurring the high costs typically associated with purchasing securities individually. In this way, mutual funds democratize access to the capital markets for investors from diverse financial backgrounds.

Types of Mutual Funds Available

There are three main types of mutual funds you should know: equity funds, bond funds, and money market funds. Each has different characteristics and risk profiles.

Equity Funds

Equity funds invest in company stocks. The performance of equity funds is directly related to the performance of the stocks in their portfolio. For example, if you hold units in an equity fund that invests in Apple (NASDAQ: AAPL) and Apple’s stock price rises, the value of your units in the fund will also increase. Equity funds generally offer higher growth potential but also come with greater fluctuations in value.

Bond Funds

Bond funds invest in bonds. Bonds are essentially debt securities issued by companies and governments to investors. As a bondholder, you agree to lend money to the issuer for a certain period and receive regular interest payments during that time. At the end of the loan period, you get back your initial investment amount. Bond funds are generally more stable than equity funds.

Money Market Funds

Money market funds are a type of bond fund that invests in short-term debt instruments with maturities of one year or less. Money market funds are considered safe investments because they do not experience the same volatility as stocks and long-term bonds. This type of mutual fund is suitable for investors seeking capital safety with stable, albeit lower, returns.

How to Invest in Mutual Funds

You can invest in mutual funds by purchasing units from a brokerage company or directly from the fund provider. When you buy units in a mutual fund, you become a unit holder in that fund. Your share of the fund’s assets and investment returns depends on how many units you own.

The price per unit is based on the Net Asset Value (NAV) of the mutual fund. NAV is calculated at the end of each business day by subtracting total liabilities from total assets, then dividing the result by the number of units outstanding. Understanding NAV is important because it determines the price you pay when buying or receive when selling your units. The better the fund performs, the higher its NAV will be.

Understanding Risks in Mutual Fund Investments

Every type of investment carries certain risks, and mutual funds are no exception. There are specific risks associated with mutual fund investments that you need to understand before starting:

• Management Risk: The possibility that poor decisions made by the fund manager will cause losses for unit holders. The quality of the fund manager significantly influences the fund’s performance.

• Market Risk: The risk of experiencing losses if the value of securities held by the fund declines. Macro-economic factors, interest rate changes, and global market conditions can trigger this risk.

• Liquidity Risk: The risk that you may not be able to sell your units quickly at a fair price if you need cash before the planned maturity date. Although mutual funds are generally more liquid than individual securities, this risk still exists.

Before investing in any mutual fund, be sure to carefully read and understand all materials provided by the fund company, including the prospectus and annual reports, which contain detailed information about fees and past performance. Remember, past performance does not guarantee future results.

Conclusion and Recommendations

Mutual funds provide small investors access to a diversified investment portfolio that would be difficult for them to create on their own. The three main types are equity funds, bond funds, and money market funds. Each has different risk profiles and potential returns aligned with your investment goals.

Before investing your money in mutual funds, it is crucial to understand these risks and the potential returns. With proper knowledge, you can make informed investment decisions that match your risk profile and long-term financial goals. Keep in mind that diversification through mutual funds is a solid strategy for building wealth while minimizing investment risks.

The views and opinions expressed here are those of the author and do not necessarily reflect the views of Nasdaq, Inc.