Mutual Fund Definition

Funds Provide Diversification

Let's suppose that you have $500 to invest in the stock market. However, you are concerned that you might lose too much of your money if you put it all in the stock of one company. So, you decide that you would like to spread your investment into several companies. In other words, you want to diversify your investment as we described in another section.

Of course, to diversify your investments, you have to put your money in the shares of companies in different industries so that if the shares of one company you invest in go down, other companies whose shares you are holding may be able to make up for this decrease if they go up in value.

Because $500 is not really enough money with which to diversify your investment, you find three other friends who have $500 each and pool your combined $2,000 ($500 from you and a total of $1,500 from your other three friends). With the $2,000, you purchase about $500 worth of stock in each of 4 companies in different industries, such as the pharmaceutical, banking, computer and automobile industries.

Each of the four people who contributed to the pool of $2,000 owns 1/4th or 25% of the investments you have made with the money. This means that each person owns 25% of the dividends, and 25% of the capital appreciation (or the increase in the value of the stock). When the investments are liquidated-that is, when the shares are sold-each person who contributed gets 25% of the amount for which you sell the shares.

The collective investment you have made with the $2,000 pool of cash is really a mutual fund. 

There are many different types of funds. There are funds that invest in technology, foreign, small-cap or any other variety of stocks you can think of. What all funds have in common is that they all need portfolio managers. These managers are responsible for buying stocks and other securities for mutual funds.

They are also responsible for selling and substituting securities in the fund as well. Professional management of mutual funds is the main reason a lot of investors buy mutual funds in the first place. These investors feel that they themselves just don't have the time or the skill to determine which stocks to buy on their own.

A fund can own as few as 20 different stocks or as many as 500 different stocks. There is no limit to the market value of the stocks in mutual funds. At the time of this writing, the biggest mutual fund had assets worth nearly $100 billion. This number changes depending on what is happening in the economy. More people put money in mutual funds during a bull market and move their investments to safer investments when the economy is doing poorly.

Fund Returns

Mutual funds usually publish the amount of money they make for investors each year in order to attract more investors. The amount they make for the investors is called the fund's annualized total return. Funds often publish their 1-year, 3-year, 5-year, and 10-year annualized total return to boast about how much they have increased investors' money.

This figure is usually given in percentage terms. For example, one of the biggest mutual funds in the world, the Vanguard 500 Index Admiral, with nearly $300 billion in assets at the end of 2015 said it had the following average annualized returns for 1, 3 and 5 years: 8.02%, 9.03% and 14.41%. Even though most funds only publish average returns, the actual returns each year are probably the best way to see how much the fund's returns move up or down.

Advertisements, rankings, and ratings tell you how well a fund has performed in the past. The more you study mutual funds, however, the more you will realize that a fund's past performance is not as important as you might think. Studies show that future returns can be quite different from historical returns. This year's "number one" fund can easily become next year's below-average fund.

This section of our website will give you an overview of mutual funds including the varieties of funds in the market and the suitability of mutual funds for Teenvestors. It will also help you understand basic terminology in the mutual fund world such as index funds, net asset value, loads, and fees.