by Gregory Gambone

Created on: August 13, 2008

Mutual funds are considered one of the most appropriate and advantageous investment vehicles that a person can own. Unfortunately, many people do not completely understand how mutual funds work, even those people who already own them! It is always a good idea to familiarize yourself with how an investment works before you put any of your money into it.

To understand mutual funds, it's first necessary to understand the basics of owning an individual stock. This concept is actually much more familiar to most people. When you buy a share of stock, you're buying a tiny little piece of a much larger company. If that company performs well and grows in value, then your tiny little piece of it will also grow in value. The main problems then come with picking which stock to buy, when to sell it, and how to determine whether or not the company is any good in the first place. Secondly, since the average investor only has a small amount of money to work with, it's impossible to build a portfolio full of the best possible stocks. You simply don't have enough money to do that, nor do you have enough time to appropriately manage a portfolio of that size.

This is where mutual funds come in. A mutual fund is simply a pool of investor money that's managed by a team of highly trained industry professionals. Instead of you trying to pick the best stocks to buy and sell, you're going to let a team of experts do it for you. Plus, since mutual funds pool together everyone's deposits, the money managers have tens of billions of dollars with which to build the best portfolio possible. The value of your account will increase or decrease proportionately with the amount of your deposits and the performance of the stocks held by that mutual fund.

To keep things simple, a mutual fund is basically a pre-arranged portfolio of stocks, bonds, and other investment vehicles, and is managed by a team of experienced professionals. Each mutual fund has a specific goal or purpose, and the portfolio that is created is geared toward meeting an investor's specific needs. For example, "growth funds" are mutual funds whose primary purpose is to increase account value in the distant future, which may mean taking short-term risks and sustaining some losses in the interim. Conversely, "income funds" have a primary goal of producing a steady current income, thereby foregoing investment choices that might dramatically increase or decrease.

With mutual funds, the challenge to investors is evaluating the performance of a fund and its money managers. There are several independent companies that report on the performance of both a mutual fund and its managers, as well as provide comparisons between similar funds. These resources should always be consulted before any money is invested.

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