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What is a Mutual Fund?

By Edited Jul 5, 2014 0 0

Almost everyone in America has heard of mutual finds, right? They're those things you have to have for retirement.... or something like that. But just what is a mutual fund? Before you take your hard earned money to a financial advisor, you should at least understand what mutual funds are, and how they work.

Before we start to describe mutual funds, think of the Dow Jones Industrial Average. The Dow is a collection of 30 of the largest companies in the United States. You've probably heard of most of these companies, and even use their products every day. Some of the 30 Dow companies are McDonalds, General Electric, Wal-Mart, Exxon Mobil, and Coca-Cola, among others. If you wanted to, you could go to a stock broker and say, "I'd like to buy stock in McDonalds..." or "I'd like to buy some stock in Exxon and Wal-Mart..."

Most people choose not to buy stock in individual companies like that, though. They realize that they are not qualified to determine whether a company is growing, shrinking, or staying the same. This is where your financial advisor comes in. Your financial advisor is someone whose job is to choose good mutual funds that will earn money for you based on your retirement date. When you give your money to a financial advisor, he will then put it into a mutual fund.

So exactly what is a mutual fund?

Well we're still not quite ready to answer that yet, so here is a bit more background information. First off, there are LOTS of different mutual funds, and each fund has a Fund Manager. These Fund Managers usually have specialties. Some specialize in understanding small companies that are just starting out. Others specialize in understanding technology companies like Apple and Microsoft, while still other fund managers specialize in companies that operate internationally, like McDonalds and Coca-Cola. These Fund Managers study companies within their expertise all day in order to determine which companies are the cream of the crop.

Now let's examine the hypothetical fund manager who specializes in international companies. The manager will study hundreds of international companies, and then pick out 10, 20, 30 or more of the best international companies that he can find; he may even choose stocks from the Dow like Coca-Cola and McDonalds. The Fund Manager will then create a mutual fund that invests money into those specific companies and call it the Super-Awesome International Fund.

Now when you go to your financial advisor, he might say something like this, "You should invest in the Super-Awesome International Fund. The Fund Manager has an excellent track record, and his fund earns an average of 11% per year." It sounds like a good idea, so you give the financial advisor $5,000 to put into the mutual fund. Once your money is officially invested into the Super-Awesome International Fund, you will then own a tiny piece of McDonalds, Coca-Cola, and all the other companies that the Fund Manager picked out.

Now obviously you are not the only person who invested in the Super-Awesome International fund. Your neighbors, relatives, and people on the other side of the country that you have never met before have probably also invested into the Super-Awesome International Fund; meaning that you, your neighbor Julie, your Uncle Gerald, and the guy across the country all own a tiny piece of McDonalds, Coca-Cola, and all the other companies that the fund manager picked out. Thus, the Fund has been mutually funded by all of you, and that is why it is called a mutual fund.

Incidentally, if you already own a mutual fund and would like to know what companies the Fund Manager invested in, then ask your financial advisor for the Fund Prospectus. The Prospectus lists all of the companies that you now own as mutual fund investor.

Did this answer your question? Leave a comment and let me know if this article has helped your understanding of mutual funds.

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