There are a lot of us who have heard of mutual funds but when asked really couldn’t tell us what mutual funds are or how they work. So how do mutual funds work you ask?
Companies that issue new funds pool money together and buy a variety of investments ranging from safe treasury bonds to risky stocks in emerging markets. Once these investments are in place these companies divide the pool of investments in to shares and distribute them to investors depending on how much money the investor invests with the company. As this pool of investments grows, so does the profitability of the investment for the investor.
The investments are monitored by a professional investor known as a fund manager. Fund managers typically have a great deal of investing experience and they use this experience to buy and sell investments according to what level of risk and what expectations of returns the investors have.
Obviously investors would prefer a low level of risk and a high return, but typically risk and return have an inverse relationship. The nice thing about mutual funds is that they tend to diversify investors portfolios by spreading around the invested money across many different types of investment.
There are a lot of different types of mutual funds that you can invest in depending on what your desired risk level is. If you are an investor that is close to retirement you probably are looking for a safe investment to protect your retirement savings, and in exchange you are willing to accept a small but reliable rate of return.
On the other hand younger investors may be more interested in a riskier fund that will make them a significant amount of money over a number of years. If this sounds like you then you may be interested in an emerging markets fund that features stocks for companies in emerging countries. These up and coming countries can provide incredible rates of return, often doubling or tripling the money invested, but they take on a lot of significant risk such as the possibility of currency rates collapsing or political uprisings that most fund investors don’t have to worry about.
Ultimately typical investors will invest in funds that are a mix of both of these classes. Fund managers may choose to balance out treasury bonds with emerging market funds, with some blue chip stocks mixed in. There are a lot of investments out there like this with the percentages of each depending on what the investors are looking for.
Mutual funds are a great investment option because investors can find exactly what they are looking for and can diversify their portfolio, but can do so investing smaller amounts of money more common to the typical investor. Remember though, always read and understand all risks and fees associated with any investment you buy, and run them by your financial planner before investing your hard earned money.