What Is A Mutual Fund?
Some people find it hard to understand mutual funds because they are not physical entities. However, they have the same level of abstraction as stocks, so if one can understand stocks, then one can understand the definition for mutual funds.
Simply put, a good mutual funds definition is a collection of funds into which an investor buys mutual fund shares, each share of which is actually composed of fractional shares of stocks of many underlying companies.
An Example To Help Define Mutual Funds
Confused still? Here's a very canonical example. The Vanguard S&P500 is a mutual fund. An investor places some amount of money, say $5,000 into it, in return getting 100 shares valued at $50 each. Each share has a value of $50 because it is in turn made up of fractional shares of stocks that add up to $50. Of course, as the prices of the underlying stocks move up and down, a share of the Vanguard S&P500 also moves up and down.
Open And Closed
There are close-end funds and open-end funds. The open-ends are so-called because investors join at any time, using the collective power of the fund to acquire shares of underlying companies and dividing them into the fractions that make up the mutual fund shares. The close-ends are so-called because they start off with a fixed amount of money put in by a primary number of investors. Other investors then partake by purchasing shares. When the shares run out, no one can join. Strangely enough, sometimes in a close-end fund the price of each share becomes higher than the combined value of the underlying fractional stocks. However, such situations are usually temporary. The close-end fund is is valued for the investing acumen of the primary investors who created the financial instrument presumably using their special insight into stock markets and business trends.
Reducing Volatility And Risk
The reason why people buy mutual funds is to reduce volatility and risk when investing in securities. Buying stock of one company means large daily fluctuations in price and total value of the bought stocks. Of course the returns are bigger, but so are the losses. If instead of buying stock from one company, what if one bought stocks from several companies. Then the fluctuations become averaged out, leading to smaller gains and of course smaller losses. In effect, one becomes invested in the stock market as a whole which is not a bad deal since stocks have on average gained 10-11% annually.
Using Collective Buying Power
However, a single person usually cannot buy stocks from many companies, not even single shares in many companies. The number of stocks in discussion here are anywhere from dozens to hundreds. Buying a single share in a hundred stocks would be a logistical nightmare as well as expensive in terms of transaction costs. This is where the mutual fund enters. Instead of an investor buying a single share in a hundred companies, the fund buys a large number of shares in the hundred companies and then divides and recombines them in such a way so as to create a share that is made up of fractions of a share of the hundred companies. The collective purchasing power is what permits individual investors to partake of this type of stock diversification. There you have it, a mutual funds definition and explanation.