Introducing the Mutual Fund

This is how smart investors diversify their portfolios.

How mutual funds diversify your portfolio

You could spend all your waking hours tracking hundreds of companies and industries to stay current with the markets and business sectors.

Or you could go with a mutual fund.

This is a hugely popular investment vehicle that owns a bunch of assets. Those can be stocks, bonds, commodities, cash—even other mutual funds. So, when you buy shares in a mutual fund, you indirectly own shares in its underlying assets.

Mutual funds allow regular people—those of us without millions of dollars to stash in the stock market—to profit from a diversified investment portfolio without much effort or expense. Once your money is in well-balanced mutual funds, you don't need to think about it very often, which is usually the best way to invest.

Buy or sell any time you like

Mutual funds date back to the 18th century, when funds were typically closed-end—meaning shares were only sold to a limited number of investors. Most modern mutual funds, developed during the 20th century, are open-end, which means anyone can buy in or sell out at any time.

Mutual fund shares don't trade on an exchange, like a stock does. Instead, they trade at the end of the day. First, the closing prices of the underlying assets are used to calculate the net asset value (NAV) of the fund's holdings. This figure is divided by the number of shares (less liabilities) to calculate the price per share of the fund. Once the price is set, the fund can issue shares to investors looking to buy, and redeem shares for people looking to sell.

Understanding mutual funds

Today there are thousands of mutual funds, holding more than $18 trillion worth of assets in the U.S. alone. Funds typically buy securities in a specific economic sector. For example, a fund might focus on big companies (large-cap), or companies in fast-growing sectors. Another might invest in emerging markets, or energy or government bonds.

Some of the most popular mutual funds track market indices, such as the Nasdaq-100. Index funds offer a simple, low-fee way to diversify and generate average market returns.

Vanguard Group founder John Bogle launched the first index fund in 1976. The approach was so revolutionary that it struggled to find investors. But eventually people caught on to the advantages of Bogle's simple, low-fee way to diversify and generate average market returns. Billionaire investor Warren Buffett once said, "If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle."

Mutual fund fees: passive vs active

All mutual funds charge fees for their services. The lowest-cost funds are passively managed, which means they track an index and don't require experts to intervene and make decisions.

Those experts tend to charge a lot, so actively managed funds charge higher fees.

Why does that matter?

Over the decades, even a fraction of 1 percent can mean that tens of thousands of your dollars end up in someone else's pocket.

Besides, research has shown that over long periods of time, actively managed funds don't outperform passive funds, when factoring in fees. Buffett once bet $1 million that he would make more money investing in a passive index fund, over 10 years, than in a hedge fund. He won by a long shot, and donated the prize to charity.

How to start investing in mutual funds

It's easy to invest in mutual funds. If you have a workplace retirement plan, it probably offers several fund choices.

If you have a brokerage account, you can usually place an online order, using the fund's ticker symbol and the dollar amount you want to invest. Your purchase will go through at the end of the next trading day.

Another option is to buy shares directly from a mutual fund provider. 

The list of popular providers includes BlackRock, Fidelity, T. Rowe Price and Vanguard. You can usually visit the fund's website and fill out a form to open an account. You'll save on brokerage fees, but you may have less flexibility to move your holdings around later.

Whichever option you choose, you can sit back and relax, knowing that with just a few steps you've put cash into diversified investments—an important step toward building your financial future.