Mutual funds are collections of stocks, bonds, and other financial assets that are owned by a group of investors and managed by a professional investment company. As an investor in a mutual fund, you own a share of the fund that is equal to the amount of your investment divided by the total value of the fund.

One of the main reasons for the creation of mutual funds was to give investors who wanted to make smaller investments access to professional management. However, mutual funds offer many advantages to investors of all types. These advantages include diversification, professional management, low transactions costs, liquidity, flexibility, low up-front costs, and services. The disadvantages of mutual funds include lower-than-market performance, risk, inability to plan taxes, and new investor bias.

There are three major types of mutual funds that parallel the major asset classes: the three major types of mutual funds are money market mutual funds, stock mutual funds, and bond mutual funds. Within the main asset class that each of the mutual funds comprises, there are many smaller asset classes that investors should consider when selecting a mutual fund. There are also several specialty mutual funds that you should know about: index funds, exchange traded funds (ETFs), balanced funds, asset-allocation funds, life cycle mutual funds, and hedge funds.

Calculating mutual fund returns is not as easy as it sounds. Too often, when investors are calculating returns, they account for only the explicit costs of trading, and they forget about the implicit tax costs; these costs can significantly reduce the amount of a fund’s return. Remember to invest wisely and account for after-tax returns.

There are five steps to buying a mutual fund: (1) determine your investment objectives; (2) choose an appropriate investment benchmark; (3) identify funds that meet your objectives; (4) evaluate the funds; and (5) make the purchase.

Mutual funds are important financial assets that can help you achieve your financial goals. However, you must understand the advantages, disadvantages, and costs of mutual funds before you begin adding mutual funds to your portfolio.

Now that you have completed this section, ask yourself the following questions:

1. Can you explain the advantages and disadvantages of mutual funds?
2. Can you describe the different types of mutual funds?
3. Can you calculate mutual fund returns?
4. Can you purchase a mutual fund?
5. Can you explain the costs of investing in mutual funds?