Key Takeaways
- Mutual fund is a single portfolio where investors put their money in to be managed by an asset management company.
- Different types of mutual funds exist that cater to different investor requirements.
- Mutual funds are easily accessible via brokers.
- Mutual funds help mitigate risk through diversification.
What is Mutual Fund?
A Mutual fund is a single portfolio where investors put their money in to be managed by an asset management company. By doing so, each investor has access to a professionally managed pool of funds. Investments are made in securities such as stocks, bonds, money market instruments and other different assets. Money managers, who are handling the funds, allocate the assets in a way that produces capital gains for the investors thus, providing them with an income. The value of a mutual fund company depends on the securities it decides to buy.
How does Mutual Fund work?
Return for the investors from mutual funds usually occurs in 3 ways:
- Through dividends on stocks and interest on bonds held in the fund’s portfolio. Investors have a choice to either reinvest their earnings to get more shares or receive a check for distribution i.e. the income a fund receives over the year.
- Selling securities that have had an increase in price and receive capital gains in returns. Most funds also pass on these gains to investors in the form of distribution
- If there’s an increase in the fund holding price and are not sod by the manager, the fund’s share price will evidently increase as well. Investors can then sell their fund share for a profit in the market!
Types of Mutual Funds
There are several different kinds of Mutual funds, depending on the type of approach an investor wants to take. 7 common examples of Mutual Funds include:
- Money Market Funds
These funds invest in short term fixed income securities like treasury bills, government bonds, commercial paper etc. They are a safe investment but with lower returns.
- Income Funds
Just as the name suggests, income funds purpose is to provide the investor with a steady income. These funds buy investments like government bonds, investment-grade corporate bonds and high yield corporate bonds. The latter are usually riskier than government and investment-grade bonds. Since earnings from this fund are regular, tax-conscious investors usually avoid this.
- Equity funds
These funds invest in stocks their aim is to grow faster than the aforementioned funds. As a result, there is a higher risk associated with this in losing money. Investors can choose from different types of equity funds including the ones that pay dividends (growth stocks), value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, income funds or any combination of these.
- Balanced Funds
In these funds, there is a mix of fixed income securities and equities with the aim of achieving higher returns than risking losing money. These funds tend to have a greater risk than fixed-income funds, but lesser risk compared to pure equity funds. Aggressive funds hold more equities than bonds while conservative funds hold fewer equities than bonds.
- Index Funds
An index fund mimics the composition and performance of the financial market index. These funds have lower expenses and fees and follow a passive investment strategy.
- Specialty Funds
This mutual fund primarily invests in a single industry such as real estate, energy etc or mandate such as socially responsible investing. Since there is no diversification, there is a high risk associated with investing in a speciality fund.
- Funds of Funds
As the name suggests, these funds invest in other funds. Like balanced funds, they work to make asset allocation and diversification easier for the investors. They are more inclined towards expensive ratios than other mutual funds.
Benefits of Mutual Fund
- Accessibility – Mutual funds are easily accessible to investors via their brokerage firms
- Diversification – One Mutual fund can achieve diversification by investing in many different investment securities. Moreover, their diverse nature is what helps mitigate risk and the impact it may have on the investor’s returns.
- Affordability – Mutual funds have relatively low minimums.
- Easier Management – Mutual funds are handled by professional so that investors do not really have anything to worry about
What is Risk profiling?
Risk profiling is determining how much risk an individual is willing to take and based on that, it is important in determining the appropriate investment allocation for a portfolio. Risk profiling helps the organization in mitigating the harmful impacts of risks taken, that can potentially go wrong.
In terms of investment, if an individual is willing to forgo potential appreciation of his asset over his fear of devaluation, he is risk-averse. Similarly, if an individual is willing to take the gamble on the potential increase in his asset’s value, he is a risk seeker. An individual’s risk preference is evaluated by reviewing their assets and liabilities. Having assets more than liability indicates risk-aversion behavior and shows the individual’s inclination towards playing safe.
It is important to note that failing to minimize risk can lead to negative consequences. A company can suffer from falling stock prices, lower revenues and thus, potential bankruptcy.
