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August 01, 2007

Definition of Mutual Funds and the Importance of Diversification

Posted in: Retirement Investing

A mutual fund, simply defined, is an investment vehicle which allows a group of many different investors to pool their money together with a clear financial objective - to make money. It consists of an extensive collection of stocks and/or bonds, which is managed by a professional or group of professionals called an investment advisor. The mutual fund was created for those investors who feel investing their money by themselves to be too risky or just not savvy enough, but who still want to take benefit of the shared market. And benefit they do.

Mutual Fund Shares

Shares in the plan are purchased for you according to the rules of the plan and many restrictions on investment and redemptions apply. The shares are issued or redeemed by the investment advisor(s) typically in large blocks. These professionals issue and redeem shares throughout the day to keep the mutual fund making money. Mutual fund share prices are determined at the end of each business day by adding up the current value of the securities in the portfolio (after any expenses) and then by dividing the sum by the total number of shares outstanding.

Mutual Fund Diversification

Diversification simply means that the fund in which you put your money is buying stock or bonds in many different companies across an industry, index, domestic / international / foreign locale, or some other classification.  The beauty of the mutual fund is that it allows the personal investor to buy into a single fund without having to buy shares of each individual company included in the fund.  There is one share price for the mutual fund, which is diversified over many companies.  Most mutual funds even allow the personal investor to buy fractions of a share of the mutual fund, allowing you to buy in for just a few dollars.

For example, I have set my fund allocation with Vanguard to include a international mutual fund called International Growth Inv, with a 5% allocation limit.  And with the small contributions I was making into the fund, I was buying less than 8% of 1 share each time I made a contribution.  This is very good news to the small time investor, who wants diversification without giving up thousands of dollars.  So, coupling the power and savings of pre-tax dollars in a Traditional IRA with a strong diversification model, we can all afford to participate in a wide range of companies, and their profits.

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