What is a Mutual Fund? Risks and Advantages

What is a mutual fund?
From the words “mutual” and “fund”, a mutual fund is a collective investment system that pools funds or money collected from several investors to invest it in stocks, bonds, real-estate, short-term money, market instruments and or other types of securities. A fund manager trades the pooled fund in a regular basis. The net profit or losses are then usually distributed to the investors annually.

Risks:
All investments promise returns. However, they also involve risks. Investors on mutual funds may suffer from different types of investment risks. These risks may also depend on what type of investment the fund manager has the fund invested. An example is if the fund is invested in bonds, it may encounter risks such as credit risks and interest risks. Credit risk is the possibility that a bond issuer will fail to repay interest and principal in a timely manner – also called default risk. While interest risk is the possibility that a bond fund will decline in value because of an increase in interest rates. On the other hand, if the fund is invested in stocks, it may face risks such as industry risks and income risks. Industry risk is the possibility that a group of stocks in a single industry will decline in price due to an unfavorable business activity in that industry. Further, income risk is the possibility that dividend income will decline due to poor financial performance of the company where the fund is invested. Mutual funds may also suffer risks such as currency risk, inflation risk, market risk, political risk and management risk.

Advantages:
Mutual fund became a popular investing vehicle because of its many advantages over the other kinds of investments. The following are the five advantages of putting your money on mutual fund:

Diversification
Asset diversification is an ideal rule of investing. It is used to manage and eliminate investment risks. Diversification is the process of mixing investments within a portfolio. A single mutual fund can hold securities from hundreds or even thousands of issuers or industries. Consequently, this ability reduces the risks of a serious loss due to problems brought by a single issuer or company.

Professional Management
Every mutual fund is managed by a professional fund manager. This manager uses the invested money to buy and sell stock, bonds and other types of investments that he or she has carefully researched. Hence, if you will invest in a mutual fund, you don’t need to do a thorough research on each of your investments. The manager does all the professional research and management of your funds and investment.

Liquidity
Mutual funds can be purchased and sold at any time like regular shares of stocks. This advantage gives the investors easy access and liquidity of their funds. With mutual funds, investors can easily get in and get out from the investment vehicle.

Economies of Scale
Investors can reduce transaction costs by buying more shares in a mutual fund. You can also be able to diversify your investments without the numerous commission charges in doing such. Mutual funds can make transactions on a larger range at a cheaper cost.

Divisibility
Small investors don’t have the amount of money to buy large selection and variety of securities. Further, commissions and brokerage fees add up to the cost of buying investments such as in bonds and in stocks. With mutual fund, investors can acquire shares in small denominations for as low as $100 minimum in some mutual fund companies.

Mutual fund is one investment vehicle that promises certain yield without facing too much risk. However, this investing opportunity should be always adopted with careful considerations from analyzing trends to comparing other alternatives. Although a mutual fund has its own professional money manager, you will still be the ultimate manager of your own fund or money.

Reference:
Finance Yahoo – Advantages of mutual funds
Wikipedia – Mutual Funds
NASDAQ – Advantage of mutual funds

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