For your average individual investor, mutual funds are one of the simplest, most effective way to start building capital. Today, more investors are relying on mutual funds to grow their wealth than ever before. If you are considering joining their ranks, it is important to first develop a solid understanding of what mutual funds are, how they work and their potential advantages and pitfalls.
A mutual fund is collection of stocks, bonds and other investments handled by a professional fund manager. These types of investment pool money from many different investors, allowing each individual greater purchasing power than they would have investing on their own. Every investor possesses a share of the fund, which represents investments in many different stocks, bonds and other assets.
Though mutual funds carry attractive benefits, they also come with their share of limitations and disadvantages. Review the guide below to learn everything you need to know to determine if a mutual fund investment is right for you.
How Do Mutual Funds Work?
When you invest in a mutual fund, your money is pooled along with the money of other investors invested in a collection of assets known as a portfolio. Stocks, bonds and other assets in your portfolio are selected by a professional fund manager. It is the job of the professional fund manager to actively manage your investments by researching companies and analyzing market conditions to make investment decisions according to the mutual fund’s objectives.
The cost of each share of a mutual fund depends on the fund’s net asset value (NAV). A fund’s NAV is based on dividing the total value of all the securities in a portfolio, minus any liabilities, by the number of outstanding shares.
How You Make Money Off of Mutual Funds.
You can make money off mutual funds in one of three ways. The primary methods for profiting from mutual fund investments include:
- Redeeming your shares at a higher NAV
- Receiving dividends
- Receiving capital gain distributions
When you sell or redeem your shares after the market value of your mutual fund increases, you will receive the fund’s current, higher NAV, minus any redemption fees. If a mutual fund earns dividends from stock investments or interest from bonds, this money is passed to investors in the fund, minus fees. When a fund sells a stock at a higher price than it was purchased for, it will dispense the capital to gain to investors, minus any capital losses, at the close of the year.
Types of Mutual Funds
Though there are many different types of mutual funds, most can be categorized into one of four types. Review the basic categories of mutual funds below.
- Equity funds
- Fixed-income funds
- Money market funds
- Balanced funds
Equity funds or stock funds are mutual funds that invest primarily in stocks. Fixed income funds, or bond funds, invest in bonds from corporations or governments. Because bonds are considered low-risk compared to stocks, fixed income funds are generally considered a safer investment than equity funds.
These types of funds are invested into certain kinds of risk-free, short term securities issued by the government or U.S. corporations. An even safer investment than fixed-income funds, money market funds strive to keep their NAV at a steady $1 per share, though they may fall below this if investments perform badly.
A balanced fund, or hybrid fund, features a combination of stocks and bonds. Some may even include a money market component. The goal of such funds is to offer investors a blend of income, security and capital gain.
Advantages of Mutual Funds
Mutual funds carry many advantages, particularly for newer, individual investors. The main draw of a mutual fund is the perk of having a professional fund manager handle investments for you. Mutual funds are managed by a dedicated expert, whose job it is to research companies, analyze the current market and make investments. If you do not have the experience, resources or time to oversee your portfolio, a mutual fund is a comparatively inexpensive way to enlist the services of an investment professional to do this for you.
When you invest in a mutual fund, your investments are spread across more than 100 securities, often from a range of companies across a variety of industries. By distributing your risk across many diverse investments, you protect your finances by improving the likelihood that a fall in one asset will be offset by increases in others.
Mutual funds trade in large amounts of assets, so transaction fees are less than what you would pay for a smaller-scale transaction.
Investing in mutual funds is relatively simple and affordable. There are many banks and financial institutions that offer in-house mutual funds with shares at a low minimum investment. Shares can be easily sold for the mutual fund’s current NAV, minus any redemption costs. As a mutual fund investor, you can also make additional investments or reinvest profits from capital gains distributions and dividend payments.
Disadvantages of Mutual Funds
As with any form of investing, mutual funds are associated with certain risks and drawbacks. When you invest in a mutual fund, you pay for the cost of organizing, distributing and managing a fund in the form of fees like transaction charges and redemption costs.
All investments, including mutual funds, carry the possibility of loss due to the performance of financial markets. If you invest in mutual funds, you could lose money if the assets within the fund drop in value. Market risk can be reduced by the diversification offered by mutual funds, but it cannot be eliminated.
Though diversification is an important strategy to employ when investing, excessive diversification could result in low returns. If a mutual fund has a few investments in many different companies, high returns from a handful of these investments will not make a substantial positive impact on the return as a whole.
Despite associated drawbacks and risks, mutual funds represent a powerful investment strategy. By investing in a mutual fund that pools your money with other investors and is supervised by a professional fund manager, you can create a portfolio that you many not have been able to as an individual investor.