What is a Mutual Fund?

Every one who knows even a little about investing knows about “diversification.” It is one principle of wise investing that is easy to understand.

Some of the most highly rated stocks have suddenly fallen into disfavor and lost value leaving owners in dismay. Not long ago there was a large group of happy Enron stock holders; today there is a large group of Enron Creditors Recovery Corporation members.

One way to avoid being caught in such a trap, having too much of our money in too few investments, is to invest in mutual funds. A mutual fund is a single fund that invests in dozens or even hundreds of different stocks, or bonds, or a combination of the two. Or, as in the case of money market mutual funds, in short-term debt instruments.

Of course, simple is never left alone. And that is certainly the case here. The first complexity comes with the choice of stocks and bonds in the funds. The options are almost limitless and there are thousands of funds available, each with a different selection.

Many funds select stocks only from certain sectors of the market. Examples might be utilities, tech stocks, or international funds. Others relate to certain social views such as “green stocks”.

People often choose funds based on the manager of the fund more than the stocks in it at a given time. Some years ago I invested in the Magellan Fund solely because of the reputation of Peter Lynch, its manager. It was one of the best investments I have ever made, multiplying my money several times in just a few years.

For the average investor, the most important type of mutual fund to know about is the “index” fund. Index funds invest in all the stocks in their sector or index. The two most important of these are the total stock market index fund and the Standard & Poors 500 index fund.

Many people buy mutual funds through brokerage firms. Banks and other financial firms often have departments where these funds can be purchased (note the sign on the door that points out that these funds are not government guaranteed as are regular bank deposits). The least expensive way is to buy directly from firms like Vanguard or Fidelity.