Understanding Mutual Funds

“The higher the risk, the greater the yield!”

This is a very famous line in the business world.  It is a common belief that high-yield investments entail high amounts of risk and a filthy sum of money, to boot; hence, it is limited only to the rich.  Stocks, bonds, and treasury bills are the best known securities.

A mutual fund is a professionally managed form of collective investment plan that gathers money from a large number of investors and invests it in bonds, stocks, short-term money market instruments, and/or other securities.  More than $26 trillion is the current worldwide valuation of all mutual funds. Mutual funds are not an American invention. The first was started in the Netherlands in 1822, and the second in Scotland in the 1880’s.

Composition of Mutual Funds

First, there is the equity fund which is primarily composed of stocks, of similar or distinct characteristics.  These are categorized depending on the particular attribute that generally defines all of the “included” stocks.  There are growth funds, which are made up of stocks demonstrating capital appreciation, while there are value funds that seem undervalued initially yet show great potential for future growth.

Second, there is the bond, which is either sold by the government (government bond) or by private security companies (debt instruments).

Lastly, there is the balance fund which includes both government funds and common stocks.

It is important to note however that in US, there are three basic types of investment instruments/accounts, namely, open-end funds (a.k.a. mutual funds), closed-end funds and unit investment trusts.  However, in other countries, mutual fund serves as the catch-all term for investment.

Advantages of Mutual Fund

Like any other investment, mutual funds have something good to offer.  What edge does it have over the rest of investment vehicles?

For one, diversification is possible.  One can buy stocks from different industries and bonds from different issuers; mixing of specific investments is the name of the game.

Second, the concept of divisibility is present.  Investors can buy mutual funds in smaller denominations, ranging from a minimum of $100 to $1000 while reaping the benefits of dollar-cost averaging.

Third, getting in and out with relative ease is another thing.  That is to say, mutual funds offer liquidity at a cheaper rate than do stocks and bonds.

Fourth, the principle of economies of scale is very evident.  For most businesses, when one buys in bulk, there’s always a corresponding discount.  As mutual funds grow, the fees usually decline.  After all, “as the fund asset increases, its operating expense ratio decreases,” averaging to a 28% reduction.

Lastly, the risk involved is not as high as that of other investments.  Since you get to diversify, when one security fails, the rest of the holdings may balance off the loss.  All forms of security and all sectors cannot fail at once.  It is because of this notion then that mutual fund is normally dubbed as “risk-free.” Of course, this is not true, strictly speaking for mutual funds are still susceptible to market risks.  As Robert Kiyosaki said in his book Rich Dad, Poor Dad, “There’s no such thing as risk-free.  It’s the investor that makes an investment risky or not.”