A mutual fund is a managed investment where
investors' money is pooled together and the fund's manager invests it
all in a variety of financial instruments - presumably making much more
money than if the individuals invested on their own (although, sadly,
that's not always the case).
Why would you do that?
Well, let's embark on a thought experiment, shall we?
Well, let's say you had $100 to invest and you bought $100 worth of stock in company A.
If that stock goes up, you make money. If that stock goes down, you lose money.
So, by investing in that one company, you are basically putting all your investment eggs in one basket, so to speak.
Now, let's say you took that $100 and bought $50 of stock in company A and $50 of stock in company B.
If stock A goes down 5% and stock B goes up 10%, your overall portfolio will be up 2.5% (Investment in A will be worth $47.5 and investment B will be worth $55 = a total of $102.50 - an overall a gain of 2.5%).
Sure, you'd have been better off investing everything in B, but that's hindsight. How confident are you that every stock pick you make will be a winner (if you're that confident, do you mind sharing your wisdom with the rest of us?).
By investing in 2 different companies, you're hedging your bets a bit, making the whole investment a little less risky.
But, what if you could instead invest in 100 companies? Wouldn't that be even less risky?
That's where mutual funds come in. After all, it would be pretty hard to buy $1 of stock in 100 different companies. So mutual funds do the work for you, pooling your money with other investors and investing the money according to whatever philosophy the fund is designed to follow - growth, retirement by a certain date, international stocks, whatever.
No muss, no fuss and all the work is done for you and your money is managed by a professional. Not a bad deal.
**This post has been selected for the Carnival of Road to Financial Independence #13!
**Rich Girl Lingo is a periodic feature of The Next Rich Girl, where I try to break down the financial terms that we all need to know if we're going to get rich. Check out a few other entries: Stocks, Bonds, Bears and Bulls
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