If you don’t want to invest in individual stocks, another popular investment choice is mutual funds. Investing in individual stocks has higher risk as compared to mutual funds. Mutual funds are indirect investment through which you can invest in stocks and bonds. Since mutual funds usually work with a basket of stocks rather than a big position in just one stock, their risk is much lower than individual securities. For example, a mutual fund specialized in energy sector will invest in 10 to 15 stocks in the energy sector with a limit on the size of each position. This allows a mutual fund to spread the risk over a wider spectrum and also take full advantage of the growth potential of each stock.

What exactly is a Mutual Fund?

A mutual fund is a portfolio of stocks, bonds, or other securities that is collectively owned by hundreds or thousands of investors and managed by a professional investment company. The shareholders are people who have similar investment goals. Each fund has specific investment criteria, which are spelled out in its prospectus, the official booklet that describes the mutual fund. Investors then know what they are getting and can match their objective to that of a fund. The pooled money has more buying power than one investor alone, so that a fund can own hundreds of different securities. Thus, its success is not dependent on how just one or two companies perform.

A mutual fund makes money in several ways: by earning dividends or interest on the investments it owns and by selling securities that have appreciated in value. You, in turn, make money in the form of dividends and interest that are passed on to you and the increase (or decrease) in the fund’s value. The mutual fund manager keeps constant watch on financial markets and adjusts the portfolio to achieve the strongest returns. By owning part of a fund, the hard work of selecting and monitoring stocks and bonds is done for you. The majority of mutual funds available are open-end funds, which are the focus of this unit. Open-end funds can have an unlimited number of investors or money in the fund. Managers of closed-end funds, on the other hand, decide up front how many shares they will issue and when they will sell them. The only way to purchase shares in a closed-end fund, once the original shares have been sold, is to buy them from a current investor. Occasionally, open-end funds can and do close to new investors, often because of high cash inflows that cannot be invested in a timely manner. They do not become closed-end funds, however, because current shareholders can still buy additional shares from the fund company.

When investors purchase a mutual fund, they own a piece of an investment portfolio. They share in the gains, losses, and expenses in proportion to the amount they have invested in the fund. At the close of every trading day, a mutual fund company tallies the value of all the securities in its portfolio and deducts its expenses (e.g., management fees, administrative expenses, advertising costs). The balance is divided by the number of shares owned by shareholders to arrive at the dollar value of one share of the mutual fund. This value, the net asset value or NAV, is the price your fund pays you per share when you sell.