Beginners Guide to Mutual Funds - Part I

Definition: A Mutual Fund is a professionally managed way to pool money from many investors and to invest it in stocks, debentures or other securities. People who buy mutual funds are owners of it and every mutual fund has a fund manager who trades the pooled money on regular basis.

Concept:  The income earned through the investments by fund manager and the capital appreciation realized are shared by its unit holders in proportion to the number of units hold by them.

How money is generated?

Investors --> pool their money with --> Fund Manager --> invests in --> Securities --> generates --> Returns --> passed back to --> Investors

Why invest in Mutual Funds?

i)    Diversification: Diversifying their investments can help reduce the adverse impact of a single investment. Mutual funds introduce diversification to your investment portfolio automatically by holding a wide variety of securities. However, more diversification results in less returns and vice versa.

ii)   Protecting Investors: As part of this government regulation, all funds must meet certain operating standards, observe strict anti-fraud rules, and disclose complete information to current and potential investors. These laws are strictly enforced and designed to protect investors from fraud and abuse.

iii)  Convenience: You can purchase or sell fund shares directly from a fund or through a broker, financial planner, bank or insurance agent, over the telephone, and  by personal computer.

iv)  Liquidity: It is ability to access your money in investments, readily available. Mutual funds can be sold on any business day. The price per share at which an investor redeem its value is called NAV (Net Assets Value)

v)   Low Costs: I'll explain it through example. Suppose you're five friends (investors) and you all want to buy a ABC comp. share. Problem is none of you have enough funds to buy it but after pooling your amount, you can buy its 3 shares. So you bought 3 shares of it and each of you became the shareholders of it in the proportion of your investments. Returns will also be divided in the same proportion. So paying low costs, you can hold blue chip shares.

vi)  Variety: Today there are about 6150(in India) and 8400 (in US)  mutual funds available to fit most objectives and circumstances.

vii) Professional Management: Even in bull markets, an investor needs to choose stocks and securities carefully and further commitment of time to monitor the up and downs. With mutual funds, an investor is relaxed as experienced professional manages the portfolios and that's too, full time.