Mutual funds are large pools of investor money entrusted to professional managers who try to achieve certain investment objectives. Mutual funds trace their history to the Massachusetts Investors Trust, which was founded in 1924. As of Jan. 1, 2009, there were about 8,000 mutual funds with about $10 trillion in assets.
"Passively" managed funds track a market index; "actively" managed funds follow the guidelines laid out in the fund's prospectus, which spells out what the fund can and cannot invest in.
Mutual funds offer several key advantages. The biggest is instant diversity. No investor wants to risk putting all his eggs in one basket, and a Mutual fund, which may have billions of dollars under management, spreads its money -- and thus its risk -- around. If one investment hits a rough patch, it has less of an effect on the whole. This diversity can be achieved regardless of the fund's purpose: even a narrowly focused sector fund that owns only companies in the pharmaceutical industry might own 200 drug companies -- far more diversity than most individual investors could achieve on their own.
The second advantage of mutual funds is professional management. Mutual funds have managers, teams of analysts, access to the best informational resources and the time to crunch the numbers and carry out a strategy. For people who know they need to invest but don't want to learn the ins and outs of things like the earnings multiple and the balance sheet, mutual funds offer the opportunity to outsource all the investing decisions to the experts. For many investors, this expertise is well worth the fees mutual funds charge.
Third, mutual funds are easy. They are easy to invest in and to sell. Investment companies go to great lengths to provide information about their funds on their web sites and in printed materials, so it's a snap to see what you really own and how the investment is doing. Each quarter, you'll get a statement. Each year, all your tax information will be mailed to you. Most funds will even allow you to set up an automatic draft from your bank account each month -- the whole process goes on without a thought.
Another key benefit to mutual funds is the low barrier to entry. You can open an account with a very modest sum and you can invest small sums easily and, in some cases, with few fees. You don't need to wait until you've saved $5,000 to buy 100 shares of your favorite stock -- you can start today, and with as little as $50.
Nothing's perfect, though. Be sure you're familiar with The Disadvantages of Mutual Funds.