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Mutual funds are a collection of stocks and/or bonds professionally managed by different investors or financial service companies.  These groups research stocks and other mutual funds and make all the buying and selling decisions.

Advantages of Mutual Funds
The biggest advantage of mutual funds is that the investments are automatically diversified; thus, the owner of the fund will receive a large number of stocks within the mutual fund, which lessens the risk that comes from buying individual stocks.  This diversified nature results in the fund spreading out its risk in various sectors.  When some stocks have setbacks, others can go up, thus offsetting significant risk.  Major mutual funds generally hold dozens if not hundreds of different stocks in various industries.  It is the diversified nature of mutual funds that makes them so appealing to various fund owners.

Along with the benefits of diversification, there are other reasons to invest in mutual funds.  As discussed briefly, investors who purchase these funds have professional managers who manage and monitor the portfolios.  Next, there is the issue of transaction costs.  Because mutual funds purchase and sell large amounts of stocks at a time, there are fewer transaction costs compared to what an individual would pay for individual stock transactions.

There are also the benefits of the ease of purchasing mutual funds.  Buying them is relatively simple as virtually all banks have their own line of mutual funds, and there is only a relatively small investment required.

Earning Money
There are three ways for an owner to earn money from a mutual fund.  First, bonds pay interest, stocks pay dividends, and funds pay income in the form of distribution.   Next, funds pass on capital gains, in which funds sell stocks that have had a price increase, to the investors via distributions.  Finally, the owner can sell a mutual fund for a profit if the holdings have gone up in price, yet not sold by the manager, thus resulting in the shares’ increasing value.   The fund owner normally has the choice of whether to receive a check for distributions or to reinvest the earnings for more shares.

Disadvantages
While the benefits of mutual funds are clear, there are also some potential disadvantages that should not be disregarded.  While one can view a fund’s professional manager as always being qualified to make the proper decisions regarding the investment, management is by no means infallible.  Regardless of the fund making or losing money, the manager will still receive compensation.  There is controversy whether or not such fund managers are any better than the average consumer at picking stocks.

Mutual funds are also somewhat complicated to fully understand, as many of their costs are unclear, in particular if the professional manager does not have a strong grasp or understanding of the market.  There is also a concern regarding too much diversification.  While mutual funds have small holdings in different companies in order to best protect the owner, there is also the issue that high returns from a few of these investments may not seriously affect the overall return.  Such dilution also occurs when a successful fund becomes too prosperous, and the manager may not be able to locate a good investment for all the new money.

Finally, fund managers normally ignore one’s personal tax situation when making financial decisions.  Sometimes it is to the owner’s advantage to defer a capital gains liability, which may have been triggered if the fund manager sells a security.

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