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Why a mutual fund reduces the risk of your investments

The ‘mutual fund’ is a buzzword in investing and personal finance circles. They have even been referred to as smart “investing for dummies.”  But what exactly is a mutual fund and why is this type of investment so popular? 

What is a mutual fund?

Mutual funds are often compared to a basket because a variety of investment securities are grouped together and shares of that group are divided up and sold off. As such, a share of a mutual fund doesn’t represent just one type of security, but rather a variety of securities.

In other words, a mutual fund basket would not only contain eggs from Eggcellent Eggs Company, but also cheese from Cheddar Corporations Ltd. and produce from Agroproducts Association.

Why are they so popular?

One of the defining characteristics of a mutual fund is diversity. This was also one of the reasons why they were first created, to provide accessible and “diversified investment products.”

Diversified investments like mutual funds are beneficial because they are more resilient to fluctuations in the market and resilient against losses. Furthermore, they can contain stocks from a variety of industries, bonds, and/or other assets.

Diversification

Consider this hypothetical scenario. One year, a terrible cheese fungus infects 80% of Cheddar Corporations Ltd.’s products, causing their stocks to take a hit. Consequently, folks who hold stock in Cheddar Corporations Ltd. will lose money as the stock decreases rather than increases in value.

However, imagine that same year Eggcellent Eggs Company hires Kylie Jenner to increase sales, and her fat free eggwhite omelette Instas inspire the masses to rediscover their love of eggs (or at least to feign their love of eggs on instagram).

While Cheddar Corporations Ltd. may have had a bad year, Eggcellent Eggs Company is riding a high based on smart marketing. Agroproducts Association might also, for example, have normally expected growth that year.

Considering that you own a stake in all of these companies through your mutual fund, you will benefit from the growth in Eggcellent Eggs Company and Agroproducts Association, mitigating your losses from Cheddar Corporations Ltd.

Professional management 

Aside from the benefit of being diversified, mutual funds are managed by financial professionals.

Mutual fund managers take care of the work involved in buying and trading the individual stocks that make up the funds. This requires significant research, time, and knowledge in order to determine the proper moments to buy and sell stock to gain maximum returns to benefit holders.

One downside to having a manager is that they charge holders for their services, regardless of gains or losses. 

Despite the cost of managers, many folks believe that they are worth it because of the range of difficult, time-consuming tasks they complete to keep the mutual fund healthy. Managers complete extensive research to study market fluctuations. They study risks to individual stocks and to the overall market.

Based on their continuous studies of the market, they decide into which securities they should invest mutual fund holders’ money to maximize returns. Aside from being equipped to conduct this extensive research, it is thought that managers are generally better than the average investor at avoiding emotional investment decisions.

Versatility

There is a diverse range of mutual funds to choose from. In our hypothetical example, we referred to a fund compiled of assets from the agricultural sector; dairy and produce. However, they are not limited to only one sector.

Rather, mutual funds can be made up of investment products from almost any part of the market. Some are sector-specific, such as our example. They may contain securities related to diverse sectors including social media, healthcare industry, natural resources, technology and communications, precious metals and others.

Other mutual funds, such as total stock market index funds, may include shares of thousands of securities from different sectors.  

The bottom line

Given that mutual funds are diverse, professionally managed, and versatile, it is easy to understand why they are popular amongst investors. Including these relatively resilient investments can be an intelligent investment strategy and be a component of a diversified, low-risk, profitable portfolio.

For more investment tips, check out our other articles in our Academy financial literacy library!

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