Hedge funds are risky finance firms for rich people. Here’s how they make money

Hedge funds

If you’re an average person making a comfortable salary but have no idea how to invest your money, you could always invest in mutual funds.

Mutual funds contain numerous stocks carefully chosen by investors, brokerages, or financial firms, letting you put money into what experts think will perform well on the stock market. Sure, you have to pay them 1% of your total mutual fund investment every year, but if they’re doing a good job buying and selling stocks for you, that fee is more than worth it.

Hedge funds, on the other hand, are kind of like mutual funds. They buy and sell stocks chosen by financial professionals based on performance. Yet that’s where the similarities end. In addition to just buying regular stocks, hedge funds use every investment tool available to maximize their profit. This could mean taking big risks for big gains…or massive losses.

Unfortunately, hedge funds don’t have the best reputation amongst novice investors, and for good reason. In addition to their risk-taking behavior, they’re also not as transparent as regular mutual funds, and command much larger fees.

But why do hedge funds take so many risks, and how can they possibly make so much money? The Financial Times recently created this informative cartoon on the world of hedge funds and how they make money. When you see how these multi-billion funds operate, you might want to steer clear and avoid the same risks.

If you’re relatively new to investing or want to avoid major risks in the stock market, shorting stocks and borrowing on margin are risks you should definitely avoid. While all investments involve some degree of risk, you can easily minimize your risks by investing in common stocks or ETFs. Otherwise, you’re taking a riskier chance with your money, which could lead to some heavy, avoidable losses.