Like stocks, mutual funds are considered equity securities because investors purchase shares that correlate to an ownership stake in the fund as a whole.
An equity security is any investment vehicle in which each investor is a part owner of the controlling company. If an individual investor purchases 10 out of a total of 100 shares in a given equity security, she owns 10% of the venture and is entitled to 10% of its net profit in the event of liquidation.
Investing in equity securities also grants the investor various rights to participate in the running of the company and may possibly generate regular income in the form of dividends. (For related reading, see "Introduction to Dividends.")
The most commonly traded equity securities are ordinary shares of stock bought and sold daily on the stock market. When an investor purchases a share of a company's stock, she owns a small piece of the company.
The difference between investing in stocks and investing in mutual funds is like the difference between selling your car to make a couple bucks and buying a car dealership with 10 of your closest friends.
If you simply buy and sell your own car, you get to keep all the proceeds for yourself. However, you may not turn much of a profit if you cannot afford to buy a high-end car in the first place. If you buy a car dealership as a group, you can leverage the sum of all your funds to invest in something that can generate a much larger profit. Though you have to split the proceeds, you can use your collective investment to sell a broader range of products.
Similarly, mutual funds are simply companies that allow many investors to leverage their combined funds to produce greater gains all around. Individuals purchase shares of the fund, which uses that money to invest in a diverse range of stocks, bonds, Treasury bills or other highly liquid assets. Shareholders are entitled to a portion of the profits commensurate with their financial interest in the fund. (For related reading, see "Mutual Fund Basics Tutorial.") However, shareholders must avoid wash sales, and other unethical practices.