Stocks and Mutual Funds
A mutual fund is a diverse holding of
stocks that are managed on behalf of the investors that buy into the
fund. A mutual fund allows an investor to take advantage of a diversified
portfolio without having to invest a large sum of money.
What is the advantage of a diversified portfolio?
It offers protection against rapid market losses of any one particular
stock. If a portfolio is spread across 20 stocks, if any one of those
stocks quickly loses value the effect is less than if the portfolio
consisted of that one stock by itself.
When investing it is always a good idea to diversify.
The problem for small investors is that they often don't have the funds
to buy a variety of stocks. Mutual funds allow small investors to benefit
from diversification with a small amount of money.
Besides stocks, mutual funds can be made up of a
variety of holdings including bonds and money market instruments. A
mutual fund is actually a company and investors that buy into a fund
are buying shares of that company. Shares in a mutual fund are bought
directly from the fund itself or brokers acting on behalf of the fund.
Shares can be redeemed by selling them back to the fund.
Some funds are managed by investment professionals
who decide which securities to include in the fund. Non-managed funds
are also available. They are usually based on an index such as the Dow
Jones Industrial Average. The fund simply duplicates the holdings of
the index it is based on so that if the Dow Jones (for example) rises
by 5% the mutual fund based on that index also rises by the same amount.
Non-managed funds often perform very well – sometimes better than
managed funds.
There are downsides to mutual funds. There are usually
fees that must be paid no matter how the fund performs, and the individual
investor has no say in which securities can be included in the fund.
Also, the actual value of a mutual fund share is not known with the
same precision as stocks on the stock market.
Mutual funds are often a better choice for the small
investor than either stocks or bonds. They offer the diversity that
provides cushion against sudden stock market movements and usually provide
a greater return than bonds. Of course, mutual funds can also lose value,
especially in the short term, so short term investors may be better
off with bonds which offer a set rate of return.
There are three main types of mutual funds: money
market funds, bond funds and stock funds. Money market funds offer the
lowest risk – they consist solely of high quality investments
such as those issued by the US government and blue chip corporations.
Money market funds have rarely lost money, but they pay a low rate of
return.
Bond funds aim to produce higher yields than money
market funds and therefore carry a correspondingly higher risk. All
the risks that are associated with bonds – company bankruptcy,
falling interest rates – also apply to bond funds.
Stock funds usually have the greatest potential
for profitable investment but also carry the greatest risk. The risk
is more for short-term holders of mutual funds – stocks have traditionally
outperformed other investment instruments in the long run.
There are different types of stock funds including
'growth funds' that attempt to maximize capital gain and 'income funds'
that concentrate on stocks that pay regular dividends.
Mutual funds can be an ideal investment for those
with limited funds or investment experience. Choosing the right fund
is a decision on how much risk you are willing to take against your
expected return on your investment.
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