By Paul Graham
Mutual funds are merely a diversified portfolio of managed
funds. Instead of having to invest a huge sum of money, you
chip into a pool of funds with thousands of other people.
funds are then managed by a single company, so even if one
investment flops others will suceed and you are guaranteed
1. What is the advantage of a diversified portfolio?
Diversity is good because you will have a greater chance of
sucess. With diversity, we have protection against rapid
losses of any one particular stock. If a portfolio is spread
across 20 stocks, if any one of those stocks quickly loses
value the effect is less than if the portfolio consisted of
that one stock by itself.
2. Don't put all your eggs in one basket
When investing it is always a good idea to diversify. The
problem for small investors is that they often dont have the
funds to buy a variety of stocks. Mutual funds allow small
investors to benefit from diversification with a small amount
Besides stocks, mutual funds can be made up of a variety of
holdings including bonds and money market instruments. A
fund is actually a company and investors that buy into a fund
are buying shares of that company. Shares in a mutual fund are
bought directly from the fund itself or brokers acting on
behalf of the fund. Shares can be redeemed by selling them
to the fund.
Some funds are managed by investment professionals who decide
that securities to include in the fund. Non-managed funds are
also available. They are usually based on an index such as the
Dow Jones Industrial Average. The fund simply duplicates the
holdings of the index it is based on so that if the Dow Jones
(for example) rises by 5% the mutual fund based on that index
also rises by the same amount. Non-managed funds often perform
very well sometimes better than managed funds.
There are downsides to mutual funds. There are usually fees
that must be paid no matter how the fund performs, and the
individual investor has no say in that securities can be
included in the fund. Also, the actual value of a mutual fund
share is not known with the same precision as stocks on the
Mutual funds are often a better choice for the small investor
than either stocks or bonds. They offer the diversity that
provides cushion against sudden stock market movements and
usually provide a greater return than bonds. Of course, mutual
funds can also lose value, especially in the short term, so
short term investors may be better off with bonds that offer a
set rate of return.
There are three main types of mutual funds: money market
bond funds and stock funds. Money market funds offer the
risk they consist solely of high quality investments such as
those issued by the US government and blue chip corporations.
Money market funds have rarely lost money, but they pay a low
rate of return.
Bond funds aim to produce higher yields than money market
and therefore carry a correspondingly higher risk. All the
that are associated with bonds company bankruptcy, falling
interest rates also apply to bond funds.
It should be known, however, that stocks still have the
greatest potential for profit. The risk is more for short-term
holders of mutual funds stocks have traditionally outperformed
other investment instruments in the long run. Of course, with
this added potential also comes greater levels of risk.
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