What is a mutual fund?

Buying a mutual fund is a lot like going in on a group gift or joining a co-op--with people you'll never meet. Mutual funds allow a group of investors to combine their cash and invest it. By pooling their money together, mutual fund investors can sample a broader range of stocks or bonds than they could if they were trying to buy the stocks and bonds on their own.

Many people think of mutual funds as "products." But when you buy a mutual fund, you're actually buying an ownership stake in a corporation that in turn hires a money manager to invest its money. The price of a single ownership stake in a fund is called its net asset value, or NAV. Invest $1,000 in a fund with an NAV of $118.74, for example, and you will get 8.42 shares. ($1,000 / $118.74 = 8.42.)

The underlying logic of mutual funds is that they provide diverse investments — in stocks, bonds and cash — without requiring investors to make separate purchases and trades. An individual would need more than $100,000 to build a similarly diversified portfolio of individual shares and bonds, but a mutual fund investor can send $1,000 to a fund company and find herself holding an ownership stake in a number of companies.

Mutual funds offer some notable benefits to investors.

1. They don't demand large up-front investments.

2. They're easy to buy and sell.

3. They're regulated.

4. They're professionally managed.

Mutual funds have costs, not just in terms of investment risk, but also in terms of fees. Like any investment, these funds have operating costs. Fees are disclosed in a fund’s prospectus under the heading “Shareholder fees”. The SEC does not limit the fees that a mutual fund can charge, but although the SEC limits redemption fees to 2%.