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Investing 101: What is a Mutual Fund?

| September 01, 2016
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In our Investing 101 series, we tackle basic financial topics that many people might be afraid to ask about. 

No worries, this is a safe place. 

Our previous post covered bonds, while this post covers mutual funds; another basic element you will find in an investment portfolio.

A mutual fund is a collection of investments nicely packaged in order to make investing easy.  The original idea behind mutual funds was to pool capital together enabling smaller investors to efficiently manage their investments.  You can find mutual funds that own just about any collection of investments that you can imagine.  The most common funds own stocks, bonds, or a combination of both.  Some might be dividend focused or buy only international stocks. 

Abraham van Ketwich is considered the creator of the first “pool of money” which allowed people to invest their money together.  His vision was to allow ordinary citizens the opportunity to own a diversified group of assets.  The year was 1774.  This concept eventually flourished across Europe and by the late 1800’s made its way to America.  In the 1950’s, the mutual fund industry began to weave its way into the everyday investment landscape.  The industry grew rapidly in the 1960’s, and it was in 1974 that a little company called the Vanguard Group came into existence.  Needless to say, the industry has come a long way since then.

Prior to mutual funds, most investors owned individual securities directly.  Maybe an investor would own shares of AT&T, General Motors, and Proctor & Gamble; however, for most investors, taking the time to research, stay up to date, and track the progress of several companies was an unwanted task.  Enter mutual funds. 

Through a fund, investors could choose a strategy or risk level and then hire a professional to choose General Motors or Ford (or both), and whether to buy more shares if prices fell, or to get out of dodge as quickly as possible when the CEO retires.  Most mutual funds own dozens if not hundreds of companies, which allows the overall risk level of investors to be easily spread out much farther than owning shares of stock directly.  This remains the primary value proposition that mutual funds offer investors today.

To the right, you see a (very) basic visual picture of a mutual fund.  An investor decides that they want to focus on owning stocks that pay dividends (excess profits paid out to shareholders).  The investor then researches mutual funds that have a dividend focus.  In their research, they’ll analyze fund costs, past performance, and the fund manager.  By purchasing shares of the “ABC Dividend Fund,” their money will actually be invested in Proctor & Gamble, General Motors, and AT&T.  The fund manager might like the future prospects of AT&T the most, and therefore put more of the money into AT&T stock than the others.  Over time, the fund manager might choose to sell all shares of AT&T and invest the money into Exxon Mobil.  Making these types of decisions is why investors pay the fund company. 

In summary, mutual funds offer investors a simple method to gain diversification in their portfolio.  Desirable mutual funds are consistent performers over the long term that have a disciplined strategy and investment process that can be replicated.  Incorporating these world class, low cost mutual funds is an excellent foundational step towards creating a diversified, long term portfolio.

 

Check out our other Investing 101 topics:

What is a Stock?

What is a Bond?

What is an ETF?

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