This was a comment I originally posted on another post, and some encouraged me to post it as an ELI5. So here we go...
Mutual funds are excellent ways to invest in the stock market that lets you invest in a lot of things at once through one basic vehicle without the investor having to sift through and make the individual investment decisions yourself. The manager does it all for you, and you get the benefit of being able to "invest" money with a general concept or target that each fund focuses on.
But what exactly are mutual funds?
Think of mutual funds as baskets when you go to the grocery store. You're not actually buying the basket when you get to the checkout, you're buying the things in the basket, and your cost is based on the value of the things in the basket. Mutual funds work exactly the same way.
Mutual funds are baskets that hold all sorts of different stocks, bonds, cash, real estate, you name it. The value of the mutual fund, however, comes directly from these investments. As the value of the investments in the basket goes up, the price of the fund goes up. This is how you make your return. Similarly, though, as the value of an investment goes down, the price of the fund will go down. Some funds hold as few as a couple dozen stocks, while some hold thousands. There is a huge amount of risk avoidance from the diversification by holding so many different things in the "basket". If the price of one thing goes up or down, it's only "one" thing. That one thing may only make up 0.5% of the basket, so if it tanks, you still have 99.5% of your money, but if it goes up 100%, you're now at 100.5%. The magic of mutual funds is how all the investments in the basket work together to grow and create returns.
When you buy in to the fund, the managers take your cash and add to the holdings based on their current allocation. Similarly, when you sell shares of a fund investments are sold to cover your shares and they send you cash. (They actually hold it in a very small cash reserve to manage these inflows/outflows, but over time they are moved to the investments themselves.)
There are two basic types of mutual funds. Actively managed funds have a whole slew of advisors that do diligent research and make investment selections based on the stated goal of the fund and their analysis. There is a cost to all of that work, though, and as such they have much higher fees (known as "expense ratios"). There is risk, though, that the management team's research yields investments that aren't the best, and that's why it's incredibly hard for these funds to "beat" the market. Some do, but most do not, especially when expenses are taken into account.
The other type of fund is called an "index" fund which is "passively managed". These funds try to mimic indexes such as the DOW, S&P 500, Russell 2000 and so on, which means they require significantly less management, research and overhead which translates to substantially lower fees. As the market goes, so do these types of funds based on what index they're trying to mimic. This avoids the risk above that the management team picks bad investments, but you also potentially miss out on a really good run of good investment decisions by the fund managers because there is no "active" management.
You can read about the holdings of an individual fund by reading its "prospectus", a legally mandated disclosure document that gives you information about the fund and what it invests in, as well as on popular investment websites such as Morningstar.
Submitted April 04, 2017 at 09:20PM by gobigorange86 http://ift.tt/2n9cNVa
