Recently, I received a lengthy email from a reader who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “personal finance 101″ series to answer and explain some of her questions.
A mutual fund is an agreement between a large group of individuals to invest their money collectively in any number of things. Generally, this involves each member giving some amount of money to a fund manager, who takes their money and invests it for them. The proceeds from this investment, minus expenses, are then returned to the original investor.
What’s the point? I can invest money on my own. That’s true, and many people with a substantial amount of money to invest perhaps shouldn’t bother with mutual funds – they should have their own investment manager.
However, mutual funds offer one big advantage that a smaller individual investor can never have: they allow you to be diverse without investing a lot of money. For example, let’s say you have $1,000 to invest. It is extremely difficult to make that $1,000 be truly diverse without spending your time managing extremely tiny investments. Even if you stick with just stocks, you’ll be in a situation where either (a) all of your money is in one or two stocks, meaning you’re carrying a pretty healthy amount of risk, or (b) the amount you have in each stock is so small that transaction fees will eat basically all of your investment, leaving you with nothing.
A mutual fund, on the other hand, can take $1,000 from 1,000 people and have a million to invest. With a million dollars, a fund can invest in a wide variety of investments without being eaten alive with fees and such.
How do I get my money out? Most mutual funds exist as shares, meaning that you buy a share in a mutual fund for a certain amount of money. As the value of the fund goes up, so does the value of the share. When you decide it’s time to sell, you can sell the share on the open market or, quite often, back to the company managing the fund.
If you have additional questions about how mutual funds work in general, don’t hesitate to ask a question in the comments, and also stay tuned this week for much more information on mutual funds.