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What are mutual funds?
Mutual fund is a financial instrument which pools the money of different people and invests them in stocks, bonds etc.
Each investor in a mutual fund scheme owns units of the fund, which represents a portion of the holdings of the scheme.
The securities are selected keeping in mind the investment objective of the scheme. Mutual funds are managed by asset management companies (AMCs).
AMCs appoint fund managers to manage different mutual fund schemes and ensure that the scheme investment objectives are met.
For fund management and other services provided by AMCs, they charge a fee to the investors. These expenses are charged proportionately against the assets of the fund and are adjusted in the price of the unit.
Let us now discuss the major advantages of investing in mutual funds versus directly in stocks.
1. Risk diversification
The biggest advantage of investing in mutual funds versus stocks is risk diversification.
Every stock is subject to three types of risk: company risk, sector risk and market risk.
Company risk and sector risk are unsystematic risks, while market risk is known as systematic risk.
What is the essential difference between unsystematic and systematic risk?
The stock price of a company may fall if the company’s financial performance is poor, even if the market rises.
On the other hand, even if the company performs well, the stock price may still fall, if the market falls.
Mutual funds help investors diversify unsystematic risks by investing in a diversified portfolio of stocks across different sectors.
Hence, mutual fund risk is much lower than individual stocks.