Mutual Funds (The Basics)

Someone in Belgium in the early 1800s had a brilliant idea...

Suppose those who had the wisdom, but not the understanding and knowledge, allowed others who did have the understanding and knowledge to use their money for the purpose of increasing the fortunes of everyone involved. By pooling their money, even small-time investors might benefit. It was a good idea that went somewhat awry in the U.S. when the stock market crashed because of many unscrupulous practices. But because it really was a good and sound idea, pooled investments have survived after undergoing much housecleaning and careful regulation.

Today, mutual funds and other investment companies provide the understanding and knowledge many investors lack. The complexities of investing in stock require the ability and time to stay abreast of developments in the stock market. Many potential investors lack this ability.

Many investors also lack the volume of money required to invest in a variety of individual stocks, and are therefore subject to the risk of a stock failing to perform as hoped. Investment companies provide a way for investors to establish their financial houses without becoming financial "experts."

For a fee, mutual funds and other investment companies choose stocks that will fulfill certain objectives such as growth, income or stability. The people employed by investment companies to perform these functions presumably have the skills and abilities which the average person has neither the time nor opportunity to develop. Thus, the investor "buys," along with securities, the expertise of the investment company.

Using investors' money, the investment company purchases a diversified (in most cases) portfolio of stocks based on its stated objectives. This diversification gives the investor still another benefit from purchasing securities through an investment company. That is, because the portfolio is widely diversified, poor performance in any one stock is unlikely to cause severe financial loss to any one investor. Instead, the investor's money continues to work through the many other stocks of the investment company's holdings, spreading the risk of loss.

Although diversification is an important aspect of most investment companies, some investment companies are not diversified. In order to qualify as a diversified company, an investment company must invest at least 75% of its assets in such a way that it meets these two requirements:

No more than 5% of its assets are invested in one corporation. It does not own more than 10% of the outstanding voting stock of any one corporation.

Any investment company which does not meet these qualifications is a non-diversified investment company. Because there is a corporate tax benefit for diversification, most investment companies are diversified.