How does a mutual fund work?

Whether you're just getting started with investing or want to be more strategic about your investments, it's important to equip yourself with knowledge of basic investing terms and concepts, like "how does a mutual fund work?"

Mutual funds are one of the most common tools that people use in their investment portfolios. That's because investing in them is one of the easiest ways for investors to participate in the stock and bond markets to help build wealth for their financial goals, such as retirement.

But you should understand a few complexities and potential risks as you decide how much to invest in mutual funds. Let's take a closer look at the basics of mutual funds and learn why you should consider including them in your investment portfolio.

A mutual fund is a collection of stocks and/or bonds that are chosen and managed by professional money managers. Mutual funds give individual investors access to a diversified mix of stocks and bonds they may not have been able to invest in otherwise. Mutual funds can be the building blocks to the foundation of your financial future by helping you save for retirement, build wealth and stay ahead of inflation.

Mutual funds allow you to buy lots of stocks and bonds all at once by purchasing a single investment. Instead of having to research and choose which individual company stocks or bonds to buy, mutual funds help you quickly build a diversified portfolio of investments.

Mutual funds are professionally managed by experts who are making decisions about lots of people's savings. Instead of building your own portfolio of stocks and bonds (which might lose value or underperform compared to other investments), mutual funds benefit from professional investment advice.

Here are two ways that mutual funds generate returns for their investors:

• Interest and dividend income. When a mutual fund invests in assets that generate income, such as bonds (which earn interest) or stocks (which sometimes pay dividends to investors, depending on the company), the mutual fund pays out those earnings to its shareholders.

• Capital gains. Mutual funds often sell stocks or bonds as part of their overall investment strategy; every time the fund sells a stock or bond at a profit, it earns a capital gain. These gains are paid out to the mutual fund's shareholders.

That means as a mutual fund investor, you own little pieces of many different companies and government/company debt; every time your mutual fund makes money, you make money too.

The price of mutual funds is based on the fund's net asset value (NAV), or the total market value of all the assets contained in the fund. If a mutual fund holds $10 million of stocks and bonds (the fund's assets) and has 1 million shares, each share is worth $10.

Let's say hypothetically that you decide to buy 10 shares of the mutual fund for $100. If the mutual fund's assets gain 10% ($1 per share) in value during the next year, your 10 shares would be worth $110 ($11 per share).

The prices of mutual funds, like the price of stocks and bonds, can go up or down each day based on overall market conditions and demand. Most mutual funds have some amount of investment risk and volatility—stocks and bonds can go up or down in price, and mutual funds are made of stocks and bonds. If you're willing to accept the risk of ups and downs in your mutual fund's day-to-day price, you may find your investment collects long-term gains.

People invest in mutual funds for a handful of reasons: to save time and money, to diversify their investment portfolio, to meet various financial goals and for the professional management.

Mutual funds are generally considered an easy, low-cost way for people new to investing to get started. There is typically a low barrier to entry and low minimum investment; you might be able to start investing in mutual funds for as little as $50 or so. Some funds may even have no minimum requirements. How is this possible? Because mutual funds are constantly buying and selling large quantities of stocks and bonds, the fund gets to pay lower transaction costs than an individual investor would typically pay.

Instead of buying individual stocks or bonds (and paying the costs yourself), you're pooling your money with hundreds or thousands of other investors at a time as part of a larger mutual fund. In this way, mutual funds provide significant economies of scale and reduce costs for everyday people who want to invest in the stock and bond markets.

Instead of picking individual stocks, which can be risky and time-consuming, mutual funds give anyone the ability to buy lots of stocks and bonds all at once in a pre-selected package. Most people don't have the time, aptitude or inclination to be professional stock-pickers. Mutual funds help you buy into the financial markets without having to research individual companies, decide which stocks or bonds to buy or worry about when to sell. Investing in mutual funds helps you tune out the noise of the stock market's daily fluctuations so you can focus on your long-term financial future.

Diversification is an investment strategy that helps you avoid losing your investment by spreading it out among various assets. This strategy helps you put your investment in the best position to reach your goals by capitalizing on the upside of the stock and bond markets while managing risk.

Mutual funds in particular can help you diversify your investments in a few different ways:

• Owning varied assets. With mutual funds, you're building a diversified portfolio of bonds, stocks, and cash—depending on your investment goals.

• Owning varied stocks or bonds. Mutual funds allow you to invest in different categories of stocks, such as "growth" vs. "value," in companies of all sizes, in the U.S. or international markets, as well as in bonds from governments or corporations.

• Owning varied mutual funds. You can even diversify your portfolio by owning multiple mutual funds, such as a potentially higher-risk (but higher-reward) growth stock fund and a less-risky fixed income bond fund.

Mutual funds are a great way to diversify your portfolio with a targeted, balanced percentage of stocks and bonds based on your risk tolerance and financial goals. You can even pick ones that do this automatically—target date mutual funds gradually adjust the percentages of stocks and bonds as the years go by.

Mutual funds can be designed with a wide range of asset allocations for different investment strategies, financial goals, life stages and risk tolerance. If you are investing money that you don't need tomorrow and you can afford to wait a few years for your investments to go up in value, you might want to invest in a more aggressive mutual fund, with a higher percentage of stocks. If you are already in retirement, you might need a more conservative mix of investments that generate income with a higher percentage of bonds and a lower percentage of stocks. If you're saving money for your child's college education that's eight years down the road, you might want more moderate mutual funds (with a balanced blend of bonds and stocks) than you would choose to invest in for your own retirement that is still 25-30 years away.

Another advantage of mutual funds is that they offer high liquidity, meaning, they are easy to sell at any time. In case your financial plans change, or you need to convert some of your stock and bond investments to cash, owning mutual funds makes it easy to keep your money accessible.

Mutual funds are professionally managed by experts who research companies, know the markets and are responsible for making the best-informed recommendations for where their clients should invest money. Think of a mutual fund as having your own built-in financial advisor who's on your side, managing your money and looking out for your long-term financial interests.

The bottom line is that no matter why you're investing, mutual funds can be a big part of your investment portfolio. Whether you're saving for retirement, saving for college or trying to make your money grow for other shorter-term financial goals, mutual funds with flexible mixes of stocks and bonds are available to help your money work harder for you.

When choosing which mutual fund to invest in, one of the biggest choices to make is whether to go with active or passive management. Here's a comparison of the two.

Actively managed mutual funds are run by professional money managers who take an "active" role in choosing stocks, bonds and other investments to allocate the fund's money. With active management, your money is being invested by financial experts who are attempting to generate a return on your investment based on the fund's goals. For example, some funds might have a goal of maximizing growth (and might own a higher percentage of volatile stocks), while some funds might have a goal of generating income (and might own a high percentage of interest-paying bonds and cash).

• Advantages of active management: You might earn a higher return on investment than you would gain from owning a simple index fund.

• Drawbacks of active management: It is hard for most professional money managers to beat the market for many years in a row.

With passively managed mutual funds, your money is invested in a diversified portfolio of stocks, bonds or cash, with the goal of matching the performance of a broad index, such as the S&P 500. While actively managed funds try to "beat the market," by outperforming the broader stock market, passively managed mutual funds are only trying to earn the same return as the overall index. "Passive" investing requires less time, attention, research and hands-on work than the active management approach. Instead of trying to pick stocks, a passively managed index fund simply buys all the stocks at once.

• Advantages of passive management: It's an easy way to invest: "set it and forget it."

• Drawbacks of passive management: You might miss out on gains by settling for "only" the broad market return.

Now that you understand how a mutual fund works, you can start investing. You can invest in mutual funds as easily as opening an account online with Thrivent or other mutual fund companies. You also likely have the option to invest in mutual funds through your 401(k) or other retirement savings plan at work.

Read the fine print about each mutual fund to make sure you understand the fund's investment mix, and decide whether it's appropriate for your goals.

You don't have to make investment decisions alone. Mutual funds give you access to professional investment management and the long-term growth potential of the stock and bond markets without the hassle and expense of building your own portfolio. Connect with a Thrivent financial advisor to discuss how mutual funds may fit into your investment plan.