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Most of us who invest, or have retirement money in something like an RRSP (registered retired savings plan) or TFSA (tax-free savings account) have much of our savings in mutual funds.

It’s a word we toss around all the time when we visit our bank or financial advisor. But how many of us truly know what they are?

What is a Mutual Fund?

A mutual fund is an organized way a group of people who don’t know each other can invest money in a large pool. They’re often run by a bank or investment organization and are led by a fund manager, who is an expert on investing and makes choices as to where this money will be invested.

You buy into a mutual fund by the unit, and the unit price goes up and down based on how well the investments are doing. If you’re putting money into a mutual fund every month, say as a monthly contribution to your RRSP, you’ll get more units if the price is low and fewer if the price is up.

The Benefits

When you put your money in a mutual fund, your small amount of dollars gets pooled with others’ money, making a big pile that can do a lot more. Since there’s a lot of money in a fund, it can diversify and invest in a range of places. As well, the fund is run by a professional investor who understands the market better than a layperson. Strict laws govern how mutual funds are run (they’re actually legally owned by the unit holders) which puts restrictions on what fund managers and financial institution can do with them.

Types of Mutual Funds

Most mutual funds have a investment theme. So while you don’t know specifically which stock or bond the fund manager is investing in at any given time, you have a general sense of where the money will go.

Overall, funds are usually categorized as either a savings fund, an income fund or a growth fund.

Savings funds include money market funds. They are often quite low risk and put short-term money into treasury bills and bonds.

Income funds include the popular balanced fund. These funds will diversity the money in a range of investments such as stocks and money market funds. Large investment organization often have dozens of balanced funds, and you can choose to go into a fund that’s conservative or one that’s taking more risks — and is more of a growth fund.

You can find income and growth funds in a variety of other types of mutual funds; it depends on how aggressive the mandate is of that specific fund.

Index funds invest in a certain stock index, such as the S&P/TSX Composite Index. Fixed income funds invest in things that pay interest or dividends, such as mortgages and certain stocks — so you get a monthly payout for these funds. Specialty funds invest in a set geographic area, such as Europe or Asia, or just a certain kind of stocks such as technology or resources. Then there are real estate and mortgage funds.

Choosing What’s Right

While a mutual fund is run by a professional, you still need to understand the basics of investing and money to choose the right fund. You’ll often work through your banker or financial advisor to determine your risk tolerance, and also get an idea if certain types of mutual funds might be doing poorly at the moment, or have a long-term bad prognosis.

You might also diversify your own money. Many people use their TFSAs to save money short term and don’t care if they make a lot of money on that investment, so often people put this money into a money market fund — they don’t get a lot of growth, but at least that $5,000 will be there next year when it’s time to go on that trip to Italy.

Young people saving for retirement, on the other hand, might opt for putting their RRSPs into an aggressive balanced fund (before you do that, check out this great series on Growth Investments for Young Investors). Or, someone who follows the tech industry may feel that tech stocks are the way to go and may ask their investment advisor to put them into a tech-oriented specialty fund.

When you pick a specific fund, you can find data on that fund to see how it’s performed in the past. This information can be helpful, at least in a limited way: if the market has dipped recently, most funds will be down. Money markets, for instance, are conservative by nature and the performance history of one of these funds will reflect that.

The Downsides

Investing via a mutual fund is still investing. If the market tanks, chances are your fund will be impacted in some way. Even if you choose a fund with a great performance history, issues in a certain sector, part of the world or other factors can change its future performance.

As well, mutual funds are run by a professional and there are fees. You may or may not see those fees, but they are there (stay turned for more on this in the coming weeks).

Over the past few decades, investing in mutual funds has become increasingly popular. It’s a smart way to put your money in clever hands and in several different investment locations. You don’t have to know the market backwards and forwards to do well as a mutual fund investor, but it still pays to understand where your money is going and why.

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