What are Mutual Funds?

Mutual funds are an excellent investment opportunity that can be used as a tool in building your wealth. 401k and other tax-advantaged retirement investments are often filled with mutual funds you can choose from. But what exactly are these mutual funds?

I've heard the opinion expressed many times that mutual funds are a safer investment than stocks, a statement which is both true and false. As we take a look at what mutual funds are, we'll discuss the truth and the error of this statement. Now, FULL DISCLOSURE: I am not an investment advisor, nor do I have years of investment experience. This is intended to be an educational introduction to what mutual funds are. It is absolutely not an endorsement of any specific mutual funds, nor should it be considered investment advice.

FALSE: Mutual funds are not some magical type of investment that offers security from the ups and downs of the stock market (although some types of mutual funds might, which we'll discuss later) while offering good return rates. Many mutual funds are actually made up of stocks, either wholly or partially. A mutual fund is a type of investment where many individual investors pool their money in order to buy securities on a scale that none of them would be able to do on their own. As of my writing this, Apple stock is currently at $130, which means it would take a $130 investment to buy a single share of Apple stock. In one Vanguard fund (VTSAX), the top 10 stocks are: Apple Inc., Microsoft Corp., Amazon.com Inc., Alphabet Inc., Facebook Inc., Berkshire Hathaway Inc., Tesla Inc., Johnson & Johnson, JPMorgan Chase & Co., and Visa Inc. To invest in just those top 10, you would need thousands of dollars. When many people invest their money in a mutual fund, that money gets pooled adding up to a significant amount (obviously dependent on how many people invest and how much they invest). That money can then be used to purchase large quantities of stocks (or bonds or other investments).

Now, there are different types of mutual funds that invest in different things. Some mutual funds invest in stocks, some in bonds, some in annuities, and some are a mix. Of these, stock-based mutual funds tend to offer the best returns. But make no mistake; what you are investing in is the stock market, and with that come risks inherent with the stock market.

TRUE: Even when talking specifically about stock-based mutual funds, they do tend to be safer than investing in single stocks. The reason: diversification. Diversification is a fancy investing term that just means not putting all your eggs in one basket (or all you money in one stock, in this case). When you invest money in any stocks, be it in mutual funds or just buying stocks, you are investing in the future of a company. Using Apple as an example, if I buy Apple stock at $130, I am betting that they are going to improve in the future, that the company is going to continue to improve their revenues. That will make their stock price increase, and I can sell it for a profit (stock market 101). But, if Apple suddenly tanks or goes out of business, I am going to lose a lot of my money.

Without investing in something like mutual funds, the average person usually does not have enough money to significantly diversify their investments. They might be able to buy a half dozen or a dozen different stocks. But mutual funds have built in diversification, being filled with hundreds, sometimes even thousands of different stocks (the VTSAX Fund contains over 3,000 stocks). What that means is that a single company performing poorly is not going to affect your investment greatly because the other companies in the fund will still hold their value or grow. That diversification is a hedge against a poor performing company, which is one of the major risks in the stock market. And that level of diversification would be extremely difficult to achieve on your own because it would take a huge amount of money. This leads to mutual funds being a more consistent investment with less significant drops (generally speaking) than a portfolio with a dozen or so single stocks. However, it may also not grow as fast.

Other types of mutual funds may offer even more security because they don't invest in the stock market (or a small percentage of their holdings is in the market). One such type of fund are Bond funds. From Vanguard's website:

"Choose bond funds if you're looking for income and want to moderate the risks involved with the stock portion of your portfolio. These funds generally offer higher yields than money market funds and less volatility than stock funds."

Instead of buying stocks, Bond mutual funds purchase bonds, which are a lower-risk type of investment than stocks. However, lower risk also generally means lower reward, so with Bond mutual funds, you typically don't see the amount of growth you could get with Stock mutual funds.

So, as you can see, there is considerable truth to the statement, "Mutual funds are a safer investment than stocks." However, there are some caveats to that, which we discussed. Overall, mutual funds offer the average person an opportunity to invest in the stock market, where they can obtain considerable returns on their investment, while also mitigating some of the risk by offering diversification that the average person would have a hard time obtaining if they were investing by themselves.

Hopefully this article was helpful, and you now understand a little bit more about mutual funds. If you are interested in investing, find a good investment advisor in your area and let them teach you more.