When you invest in a mutual fund, your dollars are invested in a large number of shares of many companies all at once, and your investment risk is spread out over many stocks of many companies, not just one. With mutual funds, your potential for risk is less. The ups and downs in the value of your investment are potentially less with a mutual fund than with an individual stock because you are more diversified.
Most personal retirement investing today is done in mutual funds, in employer retirement plans, IRAs, or Keoghs. Mutual funds make it easy for you to invest in stocks and bonds. The two main advantages of investing your money in mutual funds are: 1) You receive professional money management by the managers of the funds; and 2) you are able to truly diversify your holdings with a small sum of money.
You can buy open-end or closed-end funds. Open-end funds are typically what you think of when you think of mutual funds: There is no restriction on the amount of shares the fund will issue, and the fund will buy back shares when investors wish to sell. Closed-end funds are sold once, then traded on exchanges like stock. Because they are actively traded, they carry more risks, and in some cases, more opportunities. Since they are generally used more by traders than by long-term investors, the remainder of this section will be limited to open-end funds.
Each mutual fund has one or more fund managers who are skilled in principles of money management. They have access to a huge database of research.
Each fund also has a particular objective. That objective is defined in the fund's prospectus. The objective could be long-term growth, current income, or a combination of income and growth. For example, the objective of XYZ fund is long-term growth. To accomplish the fund's objective, the fund manager invests the money received from its shareholders by purchasing shares of many individual companies (or leaving a small portion in cash). Some stock mutual funds can own shares of stock from a few hundred companies, thereby limiting its holdings in any one company to no more than 5–6% of all the assets in the mutual fund. This is true diversification, and your risk is less than if you invested in just one or two individual stocks.
When you invest in a mutual fund, your dollars are buying shares of the mutual fund itself at the net asset value (NAV). The NAV is the value of one share of the mutual fund calculated at the end of each trading day. Put simply, the fund adds up the value of the securities it owns plus other assets, subtracts any liabilities, and divides that amount by the number of outstanding shares.
There are many types of mutual funds. Some invest primarily in stocks, others mainly in bonds, while still others, known as balanced funds, invest in both stocks and bonds. There are even gold funds and those that invest in real estate. Some are even tax-free (you don't want these in your tax-deferred retirement plans or IRAs).
You do not need a lot of money to get started in a fund. Some funds let you start with very low minimums.
If you are investing in a mutual fund outside of an employer-provided retirement plan, you may choose to have money automatically deposited from your checking account into the fund. You receive the advantage of dollar-cost averaging as well as the benefit of a systematic investment plan. For more information on this topic, see the section Investing and Investments.