Q. My friends say I should invest in mutual funds, but I don’t really understand what a mutual fund is. Can you explain how they work and why I might want to invest?
A. Although mutual funds have been around since the late 1700s, the oldest mutual fund currently in existence was started in 1924. They have increased in popularity over the last century and are the primary investments available in many 401(k)s, health savings accounts, and 529 college savings plans. A mutual fund is best thought of as a group of investors banding together to hire a professional manager to invest their money. However, a mutual fund is actually a legal structure distinct from other similar funds, such as hedge funds, and is heavily regulated by the government to help ensure appropriate disclosure and accounting practices to protect the general public. Due to this regulation, compared with many available investments, they are quite safe from the risk of the manager running off with your money. Of course, mutual funds still carry the risks of the underlying investments, such as stock market risk for stocks and interest rate risk for bonds.
Mutual funds provide significant benefits that most individual investors should find very attractive. The first is professional management. By investing through a mutual fund, you are no longer responsible for making day-to-day investment decisions, buying and selling individual securities like stocks and bonds, monitoring the investments, or calculating returns. In fact, you can go away to a deserted island for years and know your money is continuing to be responsibly invested.
Another benefit of the mutual fund structure is that the investors benefit from economies of scale. While it would be very expensive to hire a professional to buy and sell investments for you, when thousands of investors go in together to hire the professional, the cost is dramatically reduced. The fund, by virtue of its size, may have access to investments that individual investors do not and certainly is in a better position to negotiate lower commissions, bid-ask spreads, and other expenses.
Mutual fund investors also benefit from easy diversification. While individual investors may find it difficult to keep track of 20 different stocks, they can buy literally thousands of them in seconds through the purchase of a broadly diversified mutual fund. This diversification reduces the uncompensated risk that an individual stock picker runs.