What Exactly Are Mutual Funds

Mutual funds began in Europe early in the nineteenth century, with the first U.S. mutual fund forming in 1924. They're just what they sound like: a fund created by people "mutually" pooling their money for the purpose of investing it. The people who have pooled their money (bought shares) in the fund are actually the "owners" of a company (the mutual fund), and their company goes out and invests in other companies, in government debt instruments, in money markets, in precious metals, and the like.

The owners of this investing company (the shareholders in the mutual fund) then participate In the profits or losses from these Investments, proportionately to their number of shares in the fund. Mutual fund shareholders include individuals like you and me, as well as institutions, such as banks, insurance companies, and pension funds.

One of the great benefits of putting your money into a mutual fund is that the fund's investments are being coordinated by an experienced fund manager who generally has years of documented success in the market. He or she also has a staff of specialists who continually monitor and analyze all the information that can impact the performance of your fund's investments.

This level of experience and breadth of resources are far beyond what you or I could likely hope to have if we were investing on our own. And the large pool of investment funds at the manger's disposal allows him or her to diversify or spread the fund's risk out over a number of individual securities.

Each mutual fund invests in a diversity of stocks, or bonds, or whatever type of security it's designed to invest in. The fund is therefore insulated from being devastated by a drop in a single security.

For example, if a fund invests equally in 100 different stocks, five of those stocks could lose all their value, yet your net asset value in the fund would be reduced by only 5 percent because those five stocks only represent 5 percent of the fund's holdings. Whereas, if you had invested the same amount of money you put into the mutual fund into anyone of the five companies that failed -you could have lost 100% percent of your money.

Of course it's highly unlikely that five companies held by any mutual fund would go out of business. Any fund manager who selected stocks that poorly would be out of a job in a month. What's more likely is that some stocks in the fund may go down, but other stocks held by the fund might just as likely hold their value or go up. So it's possible that the overall gains in the stocks that go up could offset or exceed the losses from those that go down.

Most mutual funds are invested in at least 100 securities. For you to accomplish the same amount of diversification would take a considerable amount of money. Even if the average price per share across the 100 companies is just $25, it would cost you $25,000 just to buy 10 shares of each stock. And that's before considering brokerage commissions. Whereas, you could invest in a mutual fund for as little as $1,000 and get the same 100-stoock diversification protection as would have cost you $25,000 when buying individual stocks.

To assure this important diversification for mutual fund investors, government regulations forbid a mutual fund from investing more than 5 percent of its assets in a single company. And the fund cannot own more than 10 percent of any company's total capitalization. The benefit for the average investor is that single stocks within a fund may rise and fall, but no one company's securities can represent a large enough percentage of their mutual fund to sink it. This helps keep their money at minimum risk. Even with diversification, your investment in a mutual fund can go down. If you're invested, say, in a "high-tech" mutual fund -a fund that invests in leading-edge technology companies -and that entire sector of the market turns downward for a period, the value of your mutual fund holdings will go down. But not nearly as much as you could have lost had you invested the same money in an individual technology company. So the diversification benefit of mutual funds helps even in the down times.

Of course, you'd only really experience the "loss" if you sold your mutual fund shares at the lower value. In most cases, unless circumstances forced you to sell, you'd just hang onto the shares and wait for the next market upturn. When you invest for the long-term, as you should, the one thing you never want to do is knee-jerk react to short-term (less than five years) marketing conditions.