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What is a Mutual Fund? - Definition, Types, Advantages & Examples

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  • 0:00 Definition of a Mutual Fund
  • 0:35 Types of Mutual Funds
  • 1:58 Advantages to Mutual Funds
  • 3:30 Examples of Mutual Funds
  • 4:30 Lesson Summary
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Lesson Transcript
Instructor: Michael Cozad

Michael is a financial planner and has a master's degree in financial services.

This lesson will define a mutual fund, a type of investment vehicle. Also in this lesson, various types of mutual funds will be explained, and advantages and examples of mutual funds will be explored.

Definition of a Mutual Fund

Let's imagine you just overheard the following conversation among three friends:

'I had a great year last year. My mutual fund was up 10%.'

'Oh, yeah? Mine was up 12%.'

'Oh, my. Mine was down 1%.'

If you have a mutual fund of your own, you might be able to jump right into the conversation. But if you don't have the slightest clue what these people are talking about, you're not alone.

A mutual fund is a basket of various investments, such as stocks, bonds, and cash. A mutual fund is funded by the investments of individual investors and institutions.

Types of Mutual Funds

For the purposes of this lesson, we'll focus on the three main types of mutual funds: equity funds, fixed-income funds, and money market funds.

Let's explore each of these briefly.

Equity funds invest in stocks of various sizes and domicile. For example, there are mutual funds that are classified as global, which have the ability to invest in both the U.S. and anywhere in the world. Mutual funds that are classified as domestic are mostly invested in the U.S. Growth funds typically invest in companies that are expected to have higher growth rates than others.

Fixed-income funds mainly invest in bond-oriented investments, such as corporate bonds and municipal bonds. You may come across a municipal bond mutual fund that is state-specific. For example, an Ohio tax-free bond fund typically invests only in Ohio municipal bond funds, so that interest received by the mutual fund holder is exempt from taxation at both the federal and state income tax levels.

Money market funds invest in high-quality, short-term debt instruments, such as government treasury bills (also known as T-bills). The returns on money market funds have historically been greater than savings and checking accounts but less than certificates of deposits. Please note that investments in money market funds are typically not guaranteed by the FDIC, as most savings, checking, and certificates of deposits are. It's important to understand this prior to investing.

Advantages to Mutual Funds

The primary advantage to a mutual fund is that your investment is pooled with those of other investors, and together your investments can purchase a diversified set of stocks or bonds.

Let's say that when you choose to begin investing, you have only a small amount to begin with, say $500. It may be difficult to adequately diversify your account with this amount because of trading fees. However, with a mutual fund, the fund may require an initial purchase for $500, but that $500 investment allows you to instantly diversify into as many holdings as the fund currently has.

Think of it this way: with $500, you could buy perhaps five stocks, investing $100 into each. If one of the stocks doesn't do well, your account could drop significantly in value. However, with a mutual fund, you may invest in 200 or 300 different companies, and if one stock doesn't perform very well, it won't have as big of an impact on your account. Diversification is the main advantage to owning a mutual fund.

Another advantage is professional management. Typically, when you buy a mutual fund, you sign an agreement that states that your investment will be managed by a professional manager. On a day-to-day basis, the manager and his team decide whether to buy or sell different securities inside the mutual fund. Not all mutual funds are professionally managed. In return for the management, you pay an expense ratio. Expense ratios vary based on the type of fund.

For investors with limited knowledge of investments or little desire to research various stocks and bonds, mutual funds may be advantageous.

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