Defining Mutual Funds

A mutual fund is managed by an investment company that
invests (according to the fund’s objectives) in stocks, bonds,
government securities, short-term money market funds, and
other instruments by pooling investors’ money.
Mutual funds are sold in shares. Each share of a fund represents
an ownership in the fund’s underlying securities (the
portfolio).

By law, mutual funds must calculate the price of their shares
each business day. Investors can sell their shares at any time
and receive the current share price, which may be more or
less than the price they paid.

When a fund earns money from dividends on the securities
it invests in or makes money by selling some of its investments
at a profit, the fund distributes the earnings to shareholders.
If you’re an investor, you may decide to reinvest these distributions
automatically in additional fund shares.

A mutual fund investor makes money from the distribution
of dividends and capital gains on the fund’s investments. A
mutual fund shareholder also can potentially make money as
the fund’s share per share (called net asset value, or NAV)
increases in value.

NAV of a mutual fund = Assets
– Liabilities
÷ Number of shares in the fund
(Assets are the value of all securities in a fund’s portfolio; liabilities
are a fund’s expenses.) The NAV of a mutual fund is
affected by the share price charges of the securities in the
fund’s portfolio and any dividend or capital gains distributions
to its shareholders.

Unless you’re in immediate need of this income, which is taxable,
reinvesting this money into additional shares is an excellent
way to grow your investments.

Shareholders receive a portion of the distribution of dividends
and capital gains, based on the number of shares they own.
As a result, an investor who puts $1,000 in a mutual fund
gets the same investment performance and return per dollar
as someone who invests $100,000.

Mutual funds invest in many (sometimes hundreds of ) securities
at one time, so they are diversified investments. A diversified
portfolio is one that balances risk by investing in a
number of different areas of the stock and/or bond markets.
This type of investing attempts to reduce per-share volatility
and minimize losses over the long term as markets change.
Diversification offsets the risk of putting your eggs in one
basket, such as technology funds.

A stock or bond of any one company represents just a small
percentage of a fund’s overall portfolio. So even if one of a
fund’s investments performs poorly, 20 to 150 more investments
can shore up the fund’s performance. As a result, the
poor performance of any one investment isn’t likely to have
a devastating effect on an entire mutual fund portfolio. That
balance doesn’t mean, however, that funds don’t have inherent
risks: You need to carefully select mutual funds to meet
your investment goals and risk tolerance.

The performance of certain classes of investments — such as
large company growth stocks — can strengthen or weaken a
fund’s overall investment performance if the fund concentrates
its investments within that class. If the overall economy
declines, the stock market takes a dive, or a mutual fund
manager picks investments with little potential to be profitable,
a fund’s performance can suffer.

Unfortunately, unless you have a crystal ball, you have no
way to predict how a fund will perform, except to look at the
security’s underlying risk. If a fund has existed long enough
to build a track record through ups and downs, you can
review its performance during the last stressful market.
Fortunately for all investors, some companies use a statistical
measure called standard deviation, which measures the
volatility in the fund’s performance. The larger the swings in
a fund’s returns, the more likely the fund will slip into negative
numbers.