Mutual Fund Definition and Basics

It is a common practice of investment writers to assume that their readers are familiar with the complex essence of mutual funds. This article represents an absolute prerequisite for understanding the basic points and a starting point for further elaborations on the topic.

Firstly, a short and clear explanation of both stocks and bonds should be given in order to provide a better understanding of their correlation with mutual funds. To keep things simple and understandable, we will concentrate only on the basic variations. After this we can confidently move to the definition of mutual funds.

1. Bonds

   When you lend money to the government or a company, the respective entity issues you a bond, on which you are paid interest. Additionally, over predetermined periods of time you get back your principle. Bonds represent the most broadly used lending tool being traded on the investment market.

2. Stocks

   If you want to become one of the owners of a public company, such as Microsoft, you can apply the best known ownership tool - stocks. Other public companies include Ford, Coca-Cola, IBM and etc.

Even though there are many other types of investments, most mutual fund managers concentrate the resources of the fund in the procurement of bonds and stocks.

Mutual Fund Definition

An investment mediator that accumulates the money of a group of investors for the purpose of a more efficient achievement of a predetermined investment objective is called a mutual fund. The management of the pooled resources is called a fund manager, who is responsible for the buying of particular securities such as stocks and bonds. The investment in a mutual fund turns you into a fund shareholder.

One of the reasons for the great popularity of mutual funds is that they are very cost efficient. This means that the trading cost is sufficiently reduced due to the pooled money. Another advantage of mutual funds is referred to as diversification. 

Diversification represents the practice of broadening your investment portfolio by investing in different enterprises. In this way you sufficiently reduce your risk, since the reduction in the value of one investment may be compensated by the increase in another.

The simplest form of diversification is the purchase of several stocks, which is basically what the mutual funds do. Additionally, to further diversify, you can buy different types of stocks, later enriching your portfolio with bonds and so on. Unfortunately, this process of choosing the right investments may take you too much time, which is greatly reduced by the purchase of a few mutual funds. They automatically diversify for you in prearranged class of investments, such as international small companies, growth companies, etc.

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For the knowledge part we always recommend subscribing to the The Wall Street Journal (and save over 75%).

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