How a mutual fund works

Investing in a mutual fund rather than playing the stock market solo is something like taking a bus instead of the car. In both cases, you join a group of people who are all headed in the same direction and prefer to leave responsibility for getting there to someone else. A mutual fund pools money from a large group of investors and buys things with it -- stocks, bonds and/or other securities.

These securities compose the fund’s portfolio. Each investor owns not shares in the individual securities but shares in the fund. When the value of the fund’s portfolio goes up, investors make money. It sounds easy. But it’s not the smartest thing for everyone to do with long-term investment money.

What makes mutual funds attractive

Here’s what stock mutual funds offer and why some individuals find them attractive.

• Investments by the fund are chosen and managed by professionals. This can make the concept alluring to novices.
• Diversification spreads investments across companies and industries to lower risk.
• People who have limited money to invest can go with a mutual fund when a like portfolio of individual stocks would be priced beyond their means.
• Investors can redeem their shares at any time.

Video: Discussing the Health of the Mutual Fund Industry

Why they are not for everyone

Some characteristics of the mutual fund make it an unwise investment tactic.

• Many managers of mutual funds have shown themselves to be no better at picking stocks than the average Joe.
• Investors must pay fees to management, no matter how poorly the fund performs.
• Investors can’t easily or frequently determine the composition of a fund's portfolio or influence what the manager is buying and selling.
• What is called diversification can also be called dilution. An excessively large number of holdings means that even a brilliant mutual fund manager can’t produce extraordinarily high returns.
• Analysts say that 80% of mutual funds under-perform the average return of the stock market. The reason? Mutual funds seldom make enough money for their investors to negate the fees they charge.
• Unlike some other long-term investments, money invested in mutual funds is not insured by the federal government.
• Once they’ve got you, mutual fund companies don’t like to let you go. Some charge redemption fees when you sell your shares.

Video: Why Mutual Funds Are Dangerous Investments

Consider an index fund

When it comes to investing your money, there are many alternatives to a mutual fund. An index fund is one of them. Think of a smorgasbord where you can have a little of everything. An index fund lets you buy stock in the companies listed on a particular index. In effect, you’d own shares in all 500 companies on the Standard & Poor's 500. A stock index fund doesn’t need a team of gurus to pick and choose or buy and sell. For that reason and others, an index fund is less expensive to run than a mutual fund. Those savings are passed along to investors.

Doing it alone

Of course, a second alternative to a mutual fund is getting behind the driver’s seat yourself. This is risky and time-consuming. But if you’re interested in seeing a return on investment that’s greater than that of the market as a whole and you’re experienced enough to start selecting stocks on your own or with help from a broker, it’s time to drop those mutual funds. There’s nothing stopping you from assembling your own portfolio and diversifying a little or a lot. Resources to help you do this abound on the Internet and elsewhere.