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Mutual Funds: The Basics
(That Most People Still Don't Know)

More than 80 million Americans invest in mutual funds, to the tune of more than $6 trillion invested. Though mutual funds have been around since the 1920s, they've grown increasingly popular in the last couple of decades.

mutual funds

One of the key benefits of investing in a mutual fund? Someone else manages your investments, so you don't have to.

The Securities and Exchange Commission (SEC) defines a mutual fund as a "company that brings together money from many people and invests it in stocks, bonds or other assets."

Key Benefits of Mutual Funds

Much of the allure of mutual funds comes from two key benefits:

  1. Diversification. Because the assets of a mutual fund are invested into many different securities, mutual funds provide instant diversification for your portfolio, even if you only have a small amount to invest. You can also choose between the many different types of mutual funds out there, allowing you to diversify further.

  2. Professional Management. With a mutual fund, someone else is managing your investments, analyzing financial markets, and taking care of recordkeeping -- tasks that many individual investors don't have the time, or desire, to do.

Mutual funds also allow you to invest in securities that may not otherwise be available, or affordable, for an individual investor. And, many mutual funds have small minimum investment requirements so even beginning investors can get involved.

Finally, mutual funds offer liquidity in that you can redeem your shares at any time, making it easy to get your money when you need it.

Categories of Mutual Funds

There are two types of mutual funds: closed-end and open-end. Open-end funds (the vast majority) will create a new share to sell to an investor, while closed-end funds have a limited number of shares available. Because there are so many mutual funds out there -- more than 10,000 -- it's easier to think of them in categories, and mutual funds are classified into a number of different categories, including:

  • Money Market Funds: Generally low-risk funds that can double the interest rate of a bank checking or savings account, and give you the ability to liquidate your assets immediately.

  • Bond Funds: Typically riskier than money market funds, bond funds are generally used to produce income or stabilize a portfolio.

  • Stock Funds: Generally riskier than bond funds, stock funds are used to grow money. Where money market funds and bond funds can produce returns at a percentage or two higher than the rate of inflation, stock funds have a much higher return potential in the long run.

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    Stock funds are a popular category, and are broken down into smaller types based on the types of companies (growth funds, value funds and blend funds) or size of companies (large-cap funds, mid-cap funds, or small-cap funds) invested in.

  • Specialty/Sector Funds: These allow investors to invest in a particular industry or market segment, such as automotive, technology, health care, utilities, etc. Though less diversified than most mutual funds, they do provide more diversification and protection than investing in one company.

The Fees

There are fees involved with mutual funds that will reduce your investment returns, so learning what the fees are is essential.

Mutual funds can either be load funds, which charge a sales fee, or no-load funds, which do not. Further, different types of funds, or share classes, charge different fees. No-load funds do not have share classes, but the shares of other have three basic categories (or are a variation of one of these):

  • A Shares: Typically these are load funds sold through brokers that charge a "front-end" sales charge of 3 percent to 6 percent. This charge is deducted from your initial investment. There is also a marketing fee called "12b-1" that's usually charged with A share funds (this is deducted from the fund's assets, on average it's around 0.25 percent, and you can find information about it in the fund's prospectus).

  • B Shares: Instead of a front-end charge, B Shares have a "back-end" fee, or redemption fee, that you must pay if you redeem your shares in a certain number of years. The fee can decrease every year until, after a certain time period (usually six years), it disappears. There may also be a 12b-1 fee, which may be higher than that of A shares.

  • C Shares: C shares, or "level-load" shares, have no front- or back-end sales charges, but they have a 12b-1 marketing fee that you pay for the entire period you own the fund, similar to no-load funds that charge 12b-1 fees.

Mutual funds also have management fees and operating expenses, which are reflected in the share price, not charged directly to the shareholder. They typically range from 0.5 percent to 1 percent, but may be higher.

Finally, while mutual funds are generally regarded as good investments because of their diversification, you should be aware that there's still risk involved; loss can occur from an overall decline in financial markets. Meanwhile, mutual funds will limit your potential for making a huge profit that could occur from owning a single security whose value skyrockets. Of course, in the same vein, mutual funds also protect you from a major loss from a plummeting value, which can occur if you own a single security.

Recommended Reading

How to Get Outside Capital for Your Business Idea: A Primer

Roth IRA: If You Don't Have One, Here's Why You Should Seriously Consider One ... Especially NOW

Sources Mutual Funds 101

Different Types of Mutual Funds

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