Understanding Mutual Funds

The concept behind mutual funds is quite simple -- easy entry into a liquid, diversified, low-cost, professionally managed investment for the individual investor. However, as with many other good ideas, the best laid plans of mice and men often go awry.

Mutual funds were first developed in Europe in the 1800s. In 1924, the first mutual fund was introduced in the U.S. with the creation of the Massachusetts Investors' Trust in Boston (now the center of the universe for mutual funds).

In 1928, the spread of publicly available mutual funds began in earnest. In the 1960s and 1970s, mutual funds began to really grow as investors returned to the stock market.

Why? At the time, U.S. commission rates for buying and selling stocks were fixed and thus transaction charges took a big bite out of an individual's investment performance. The average cost of transacting stocks in mutual funds was significantly cheaper. It also allowed for diversification, which individuals were not able to achieve on their own.

However, the biggest contributor to mutual fund growth was the establishment of the Individual Retirement Account in 1981. That growth has spread over the years to 403(b), 401(k), SEP, Keogh and Roth IRA account plans.

(If you need a warm-up course on IRAs, check out Investing Basics: IRAs.)

As the financial markets progressed, the benefits of mutual funds have morphed and in some cases have become warped. For years, mutual funds have been incorrectly labeled as the lowest-cost way to invest in the market and provide tax efficiency. However, that's not true. I call this the Mutual Fund Myth.

To understand why this is so, you need to know the basics of mutual funds first. This lesson will cover many of the mutual fund basics and key terminology. In a future lesson, I will discuss how mutual funds have lost their way, what to avoid when investing in mutual finds and further explain the Mutual Fund Myth.

What Are Mutual Funds?

Mutual funds are pools of assets managed by professional investment advisers for the benefit of shareholders. These funds and the advisers who manage them are regulated under federal law and in particular, The Investment Company Act of 1940 and The Investment Advisors Act of 1940.