Imagine that you and a group of friends decide to pool your money to buy different types of fruits – apples, oranges, bananas, and grapes. Instead of buying just one type of fruit, each of you buys different types of fruit in the hope of getting the best price.
A mutual fund also works in a similar way. It is like a pool of money from many investors, which is managed by professional fund managers. These managers invest the collected money in various assets, such as stocks, bonds, and other securities like real estate, commodities, etc. Now let us understand in detail how a mutual fund works and before that, let us also understand what a mutual fund is.
What is a mutual fund?
A mutual fund is an investment medium in which capital is collected from many investors and invested in shares, bonds, and other financial instruments. This option is useful for those investors who want to get their money managed by experts and want to invest in different assets simultaneously.
How does a mutual fund work:-
You can think of a mutual fund as a big piggy bank, in which many people put their money. The money deposited in this piggy bank is invested by an expert (fund manager) in shares, bonds, or other investments of various companies.
Suppose you and your 9 friends have started a mutual fund together. All of you have given Rs 10,000 together, that is, the total amount is Rs 1 lakh. Now, this Rs 1 lakh has been handed over to a fund manager.
The fund manager can invest this money in shares of various companies, such as a car company, a tech company, and a bank. If the price of the shares of these companies increases, then all of you will benefit. And if it decreases, then everyone will suffer equal loss.
How Mutual Fund works:-
Mutual funds mainly work in three ways – capital investment, portfolio management, and distribution of profit and loss. Now let’s understand it –
1) Capital Collection:-
Friends, in actuality, capital collection means the work of a mutual fund is to collect money from small investors. Investors invest money in different schemes according to their budget and risk-taking ability. This capital is collected in a large fund.
2) Portfolio Management:-
Portfolio management means fund managers, who are financial experts, who collect money from small investors and invest this capital in the stock market, bonds, or other financial instruments. The objective of their plan is for investors to get maximum returns and reduce risk.
3) Distribution of profit and loss:-
The profit or loss from a mutual fund is divided among all investors based on their investment ratio. This profit can be in the form of dividends, capital growth, or interest.
Safety of Mutual Funds-
Before investing in mutual funds, investors first think about its safety. Will my money be safe? This is a very legitimate question. There are many mechanisms in place to ensure the safety of mutual funds. Let’s know about them in detail.
(1) Regulated by SEBI-
Mutual funds in India are regulated by SEBI (Securities and Exchange Board of India), which makes it transparent and safe. Investors are given complete information about all the schemes. This means that the Securities and Exchange Board of India (SEBI) is the regulator of capital markets in India. It ensures that the rules of all investment instruments including mutual funds are followed. SEBI ensures the safety of mutual funds in the following ways:
- Formulation of rules: SEBI makes many stringent rules for mutual funds, such as minimum investment amount, qualification of fund manager, portfolio of fund, etc.
- Ensuring compliance with rules: SEBI regularly checks mutual fund houses and ensures that they are following the rules.
- Preventing fraud: SEB takes strict measures to prevent fraud.
- Educating investors: SEB runs many programs to make investors aware of mutual funds.
(2) Benefit of diversification:-
Diversification is the biggest advantage of mutual funds. It can be understood as a strong foundation that keeps the entire investment safe.
What is Diversification?
Suppose you have a basket and you are keeping different types of fruits in it. If you fill the whole basket with apples only and if the apple crop is bad then your whole basket will be spoiled. But if you keep mango, grapes, and bananas along with apples in the basket, then even if the apple crop is bad, you will still have other fruits left. This is diversification.
Diversification in mutual funds means:-
- Investment in different companies: Mutual funds invest not only in the shares of one company but in the shares of many different companies.
- Investment in different industries: It invests not only in different companies but also in different industries such as IT, banking, automobile, etc.
- Investment in different countries: Some mutual funds also invest in foreign companies.
Professional Management: An Important Benefit of Mutual Funds-
One of the biggest advantages of investing in Mutual Funds is professional management. This means that your investments are managed by experienced and skilled fund managers. These fund managers constantly study the market, analyze companies, and look for the best opportunities for investment.
Let us understand this with an example –
Suppose you have invested Rs 1 lakh. It may be difficult for an individual to manage such a large amount and constantly keep track of market movements. But, a fund manager has the experience, resources, and team that constantly analyzes the market. They study the financial statements of different companies, analyze industry trends, and keep track of economic indicators.
Benefits of professional management:–
- Time savings: You do not have to spend time analyzing the market and making investment decisions.
- Risk reduction: Fund managers try to reduce risk by assessing risks and creating a diversified portfolio.
- Better returns: The knowledge and experience of experienced fund managers can increase the chances of better returns.
- Improved investment: Fund managers can balance investments according to market fluctuations.
But also remember this:
- The performance of fund managers may vary.
- It is important to look at the track record of the fund manager.
- Past performance is not a guarantee of future performance.
Types of Mutual Funds –
There are different types of mutual funds, which are classified based on their investment objectives, risk level, and return potential. Here is a description of some of the major types:
(1) Equity Funds: –
This fund invests mainly in the stock market. Share prices keep changing with market fluctuations, so equity funds have the potential for high returns, but also have higher risk.
(2) Debt Funds: –
This fund invests in government bonds and fixed-income securities (corporate). Bonds usually provide stable returns and are less risky than equity funds. Meaning it is suitable for low-risk and stable returns.
(3) Hybrid Funds: –
This fund invests in both equity and debt, giving investors the benefit of both stability and growth. Which provides a balance between risk and return.
(4) Other types of funds: –
- Gold ETFs: One way to invest in gold.
- Real Estate Funds: Invest in real estate.
- Money Market Funds: These are extremely low risk and offer high liquidity.