What are mutual funds?
Mutual funds are professionally managed portfolio with a combination of stocks and bonds. They are a pool of money brought together from both retail and institutional investors and the money being invested and managed by certified portfolio managers into various financial instruments.
How is mutual fund different from stocks?
Mutual fund and stock mean the same thing in theoretical term, they are both fractional ownership of a large asset. However, what distinguishes them apart is the number of companies you are entitled in your fractional ownership. If you own a fraction of stock, you are entitled to the risk and reward of one specific company, meaning the risk and reward you are receiving are higher. However, if you own a fraction of a mutual fund, you are entitled to a pool of multiple equities being bundled together. Thus, the risk and reward you are receiving are much more conservative than if you were to invest in stock alone.
How do you earn returns from a mutual fund?
- Mutual is a pool of a combination with both stocks and bonds, thus you will earn fixed interest payment from a bond in the fund, and dividends on stocks in the fund’s portfolio.
- If the price of the fund increase, you receive normal capital appreciation just like investing in stocks.
- If the fund sells its securities at a premium, the fund will receive capital gain. These gains are also pass on to investors.
Why should you invest in mutual funds?
- Professionally managed: these funds are typically managed by portfolio managers who take care of all the technical and fundamental research for you, so you can skip the work of finding the “perfect” stock. Stock research takes time, a lot time in fact, thus, investors who want to save their time to do other meaningful things often invest their money in mutual funds.
- Diversification: investing in securities could often come with extreme risk, one wrong move could result in tremendous losses. By investing in mutual funds of multiple risky assets, you reduce the holding risk greater than if you were to invest in single asset alone. The theorem behind diversification is not to put all your money into one basket- instead, spread your investment across the different assets so that losses can be minimized. Large and well-managed mutual funds often consist of stable stocks in the fund.
- Minimum capital requirement: Investing in thousands of shares of companies can be really expensive for individual investors. Some stocks can also be quite expensive, so if you can’t invest in a thousand dollar stock, you can invest a mutual fund that own that thousand dollar stock in cheap.
How to invest in mutual funds?
Mutual funds are sold at what is called Net Asset Value (NAV), and they are calculated by adding the market value of all securities in the portfolio and divide that by the number of share outstanding of the fund.
For example, if the fund has Microsoft with a market value $100B, and Apple with a market value of $500B. And the number of shares outstanding is 15 billion. Its NAV will be (100B+500B)/15B=40$.
So you can purchase this mutual fund that consists of apple and Microsoft at the price of 40$ per share.