What are mutual funds?

In basic terms, a mutual fund is a type of investment that pools money from many different investors in order to purchase other investments, such as stocks, bonds, etc. They are normally managed by a portfolio manager whose goal is to generate better financial returns than the market (e.g. the S&P 500, the Dow Jones Industrial Average or DOW, the NASDAQ, etc.). Think of mutual funds as a basket holding many different stocks, cash, bonds or other securities. The goal is to create a more balanced or less risky portfolio. A mutual fund is characterized by a ticker symbol to distinguish it from other mutual funds. For example, FTQGX (Fidelity Focused Stock Fund), FNCMX (Fidelity NASDAQ Compositive Index Fund) are mutual funds.  

Video: Mutual funds

Why investors buy mutual funds.

Investors buy mutual funds for many different reasons. They invest in mutual funds in order to create wealth, achieve financial stability and independence, plan for retirement, vacation, or education. Last but not least, by investing in mutual funds, investors leave the heavy lifting to professional fund managers who research, sell or buy stocks, bonds and other securities for the mutual fund.

How to purchase mutual funds

You can buy mutual funds from a broker (Fidelity, E-trade, TD Ameritrade, etc.) or from the fund itself. Investors buy mutual funds at the fund's net asset value (NAV). The NAV is nothing more than the amount of money you need to buy one share of the fund. Here are the steps you need to take to buy mutual funds: 1) open a brokerage account; 2) fund your account; 3) decide how many shares of the mutual fund you want to buy; 4) choose your order type. Although mutual funds are less risky investments compared to stocks, you should always read the fund's prospectus. This is a document that outlines the fund's investment strategy, fees, risks, among other things. Here's a nice little guide on how to evaluate and select index funds for your portfolio.

Benefits & risks of mutual funds.

As an investor, owning mutual funds comes with risks and benefits. If the mutual fund's price or net asset value (NAV) goes down, you will lose money and vice versa. There is no certainty that companies whose stocks the mutual fund holds will prosper or do well. To a large extent, a mutual fund's NAV is dependent upon the basket of securities (stocks, bonds, cash, etc) it holds. Many factors affect a mutual fund's share price (NAV), including but not limited to quarterly earning reports of individual companies, regulatory, political, economic and other events.

How investors make money from mutual funds.

Investors make money in two major ways. First, they earn money through capital gains. A capital gain is essentially the increase in price of a fund to a price higher than the initial purchase price. Second, investors make money through dividends. Dividends are basically free money you get for simply owning the fund or being a fund holder. Dividends are usually paid to shareholders quarterly. Not all companies pay dividends. Mutual funds are meant to be kept for the long-term. Here's a nice overview of how investors earn money from mutual funds. Check out this nice comparison between stocks, ETFs and mutual funds.