Whether you’re preparing for a big purchase (such as a new addition to your home, a stint at law school or a bubblegum-pink convertible) or prudently trying to save for the best retirement ever, mutual funds can help you.
Whatever your financial goals are, mutual funds can net you a ton of money if you’re wise about it. However, too many people don’t have a good grasp on what mutual funds are or how they work. Do you want to boost your odds of a happy and secure retirement? Then you should definitely read on.
What Is A Mutual Fund?
Mutual funds are epic-scale investment funds with professional management. Mutual funds pool money from a large swath of fund investors. Under the guidance of a fund manager, a mutual fund invests this pooled money into a diverse portfolio of securities including stocks, municipal bonds and short-term debt. Participants in a mutual fund may include individual investors or groups.
Think of it like a transatlantic flight: Because you’re pooling your money with a ton of other passengers, you can collectively pay at low-cost for what would otherwise be a very expensive service.
As with anything else involving the stock market, the more mutual fund shares you own, the greater your percentage of ownership in the portfolio.
Let’s go back to our airplane example. If you pay more money, you can buy extra seats or fly business class. If you pay even more money, you can buy a row of business class seats for you, your prized Buff Orpington hen and her 10 chicklets.
So, a mutual fund is a high-powered investment tool for anyone with any amount of money looking to make more money.
It can’t be that simple, right?
Well, it’s a little more complicated than that. But don’t fear – we’ll make understanding mutual funds super simple.
How Do Mutual Funds Work, Exactly?
A mutual fund is simultaneously an investment and a company that manages investments. Returns from these investments get distributed among stakeholders, who can then invest more money into the mutual fund.
Mutual funds are like any other companies you can invest in. A mutual fund is not run by a traditional CEO, but rather by a fund manager who is appointed by a board of directors and often owns a large stake in the fund.
If it’s like any other company, are there employees?
Not many. Usually mutual funds will employ a fund accountant, one or two compliance officers, a lawyer and sometimes a few analysts.
Want to hear something weird?
Some mutual funds invest in other mutual funds, some of which invest in other mutual funds. This spiral can go on infinitely.
How Do Mutual Funds Differ From Other Investment Products?
It’s easy to get confused when you’re looking at investment options. You might consider investing in individual stocks or bonds, for example. But how do those two asset classes differ from mutual funds?
Stocks Vs. Mutual Funds
When you buy stock in a company, whether it’s a giant such as Microsoft or an up-and-coming company that you think is going to make it big, you are buying an individual investment. You are purchasing stock in that company and nothing else. If the company performs well and its stock value increases, you’ll make money.
With a mutual fund, though, you invest money with a manager (such as Fidelity or Vanguard) that disperses your funds to a wide variety of securities. Your mutual fund might invest in stocks and bonds, of course, but the individual stocks and bonds it selects are outside of your control.
The goal with a mutual fund is to diversify your investments, thereby offering you protection if a particular stock struggles. In contrast, the goal with a stock is to invest in a particular company that you expect to thrive.
Bonds Vs. Mutual Funds
Bonds, again, are a specific investment type. You might purchase a government bond, which means you’re lending money to the federal government. After a certain number of years, you can cash in that bond and receive your initial investment back plus interest. Bonds are less risky than stocks, but the rate of return is usually lower.
Bonds, like stocks, differ from mutual funds because you are purchasing a single investment, not spreading your money into a portfolio of securities.
Mutual Funds Vs. IRAs
It’s not unusual for investors to confuse IRAs and mutual funds. But these two vehicles are not the same, though they are similar.
As you know, a mutual fund is made up of a pool of investors’ dollars, dollars that are then invested in a variety of investment vehicles such as stocks and bonds. An IRA (also known as an individual retirement account), though, is regulated by the government and allows you to put money away for retirement while gaining tax advantages.
In a mutual fund, you’ll pay taxes on any increases you enjoy when you sell your shares. With an IRA, you’ll receive tax breaks either when you invest in an IRA or withdraw money from one (depending on whether you have a traditional IRA or a Roth IRA).
IRAs also come with limits. As of 2019, you could only invest $6,000 in a traditional or Roth IRA in a year. If you are 50 years old, you can invest a total of $7,000 a year in an IRA. However, a mutual fund comes with no investment limits.
Finally, you can withdraw money from a mutual fund whenever you’d like. With an IRA, though, you’ll face a 10% penalty if you withdraw funds before you hit the age of 59 and a half. You are required to withdraw money by the age of 70 and a half to avoid further penalties.
401(k) Plans Vs. Mutual Funds
Your 401(k) plan is a retirement savings vehicle offered by your employer. You’re allowed to deposit a percentage of each paycheck into this account. Once you do this, the money is invested in a variety of savings vehicles. As with IRAs, the contributions you make to a 401(k) are tax-deductible.
How Does A Mutual Fund Work To Help You Meet Your Investment Objectives?
So, you’re interested in investing in mutual funds. That’s great. But you will have to do some work.
First, you’ll have to find a fund in which you’d like to invest. Today, there are plenty of options. The one that’s right for you depends on your investment strategy and how much risk you want to take.
There are three main types of mutual funds: equity funds (which focus on stocks), fixed income funds (which feature investments in bonds) and money market funds (funds that only invest in liquid assets such as cash and securities that have short terms, usually less than 13 months). Of these types, equity funds pose the most risk while market funds pose the least.
OK, I’m interested. How do I buy a mutual fund?
Purchasing a mutual fund is easy. You can buy them from a mutual fund company, bank or brokerage firm. Some of the bigger providers of mutual funds include Vanguard, Fidelity, T. Rowe Price and Ameritrade. You can usually invest in a mutual fund by phone or online.
Before you can invest in a mutual fund, though, you must first open an account with one of these providers. You’ll also have to determine if you want to invest in a load or no-load account. A load account is one in which you pay a commission to the company running your mutual fund. A no-load account requires no commission.
Why would I pay a commission?
That’s a good question. Investors usually open load accounts because they want to work with an investment professional who will manage their mutual fund investment and hopefully help them make more money. If you want this assistance, you’ll usually have to pay a commission.
OK, how do I make money with a mutual fund?
This might be the best question of all. And the answer? It’s a bit complicated, but you’ll generally earn money from your mutual fund in three different ways.
- Dividend payments: When a mutual fund makes a profit, it might make what are known as dividend payments to investors. You can either accept those dividend payments as cash or you can reinvest them in the fund to increase your holdings.
- Capital gains: Sometimes your fund manager might sell a security in your mutual fund that has increased in value. The profit from this sale is a capital gain. Most mutual funds will distribute that capital gain directly to investors once a year.
- Value growth: If the value of your mutual fund grows, you could make significant money. It’s much like when the value of a stock you’ve invested in rises. If you sell your mutual fund after its value has grown, you’ll keep the profit from the sale. Of course, you’ll only make money this way after you sell your mutual fund.
There are some restrictions on selling a mutual fund, though. Mutual funds are only traded once a day after the financial markets close at 4 p.m. ET.
Want To Make Fast Cash? Watch Out For Those Redemption Fees
You might hope to invest in a mutual fund, watch it increase in value and then sell it fast to make a quick profit. Be careful, though. Some mutual funds charge a redemption fee.
The fund charges you a redemption fee in order to prevent investors from selling too quickly. If you invest in a fund with the hope of making a quick profit, make sure you research the rules. You don’t want a redemption fee to swallow up any profits you could make from your sale.
Different Types Of Mutual Funds
Before you invest in a mutual fund, you need to know what kind in which to invest. There are more than 15 different types of mutual funds to choose from. Some mutual funds, like balanced funds, are comprised of many asset classes. Others, like equity or fixed-income funds, are made up only of stocks or bonds.
Among the most popular mutual funds are fixed income funds, money market funds and equity funds. We want to give you the best information possible, so here’s a list breaking down these major funds and subtypes:
- What are they?Equity funds are also known as stock funds. That’s because their investment mix is made up of stocks.
- How risky are they?These funds carry the most risk because stocks can be volatile and the investments in an equity fund can lose value quickly, but these funds also hold the potential for the greatest returns. While stocks can lose value, they can also increase in value quickly.
- Who they are right for?If you have plenty of time to hold your mutual fund, an equity fund might be the right choice. You can wait out the volatility and only sell when the equity fund has jumped in value.
- What are they?If you want less risk, consider investing in a bond (or fixed income) fund. As the name suggests, these mutual funds are made up of bonds.
- How risky are they? Bonds are generally less risky than stocks, but some are more volatile. In general, bonds issued by the federal government carry the least amount of risk. Bonds issued by corporations are riskier. Before you invest in a bond fund, do your research. You want to make sure you are comfortable with the amount of risk associated with a specific fund.
- Who they are right for?These are best for investors who have a slightly lower tolerance for risk. Bond funds aren’t the least risky of mutual funds, but they aren’t as volatile as equity funds. If you’re willing to hold onto your investment and remain patient, these funds can work for you.
Money Market Funds:
- What are they?Money market funds are the safest type of mutual fund. By law, fund managers are required to only invest in short-term investments that are issued either by the U.S. government or corporations based in the U.S.
- How risky are they?Not very. Money market funds are designed to minimize the risk investors face. This also means that the possible returns with these funds aren’t overly high. In fact, money market funds traditionally have the lowest returns because they have such low risk.
- Who are they right for?The most conservative of investors are the best fit for these funds. If you want a fund that has little chance of losing value and don’t mind that your return on investment might be on the modest side, a money market fund is a good choice.
- What are they? Prefer a more diversified investment approach? A hybrid fund (also known as a balanced or allocation fund) invests your money in a mix of different securities, which includes everything from stocks and bonds to cash.
- How risky are they?Consider hybrid funds to be a mix of equity and money market funds. The goal is not only to produce growth but also to reduce risk. So, while these funds aren’t as risk-free as money market funds, they pose less of a risk than equity funds do.
- Who are they right for?These are a good choice for investors who prefer a less volatile mix of investments. They are also a good choice if you don’t need any returns on your investment too quickly. This way, you can keep your money in the mutual fund and wait out any possible downturn in its value.
- What are they?Index funds operate a bit differently. The investments in these funds match those in a specific financial index. For example, you might invest in an index fund that’s made up of stocks on the Standard & Poor’s 500 Index. Therefore, if the index tied to your mutual fund does well, your mutual fund investment should perform strongly too.
- How risky are they?That depends on the index to which your mutual fund is tied. If your fund includes investments from a more volatile index, you’ll face greater risk.
- Who are they right for?These funds usually cost less because the managers running them don’t make as many decisions. These might be a good fit, then, for investors who are concerned about their upfront costs.
Tips For Choosing A Mutual Fund
You’re convinced that mutual funds can be a great addition to your portfolio of investments, but perhaps you’re still unsure on how to find the right fund.
Fortunately, we have some suggestions.
How Much Risk Can You Tolerate?
Your first step is to determine how comfortable you are with risk. If you want the potential for the highest possible returns, you’ll need to take some risks. If you don’t plan on retiring for many years or if you don’t need your investment to pay off quickly, investing in an equity fund might be a good decision. These funds carry the greatest risk but they also have the potential to pay off with the biggest returns.
If you’re more conservative and worried about your investments losing value, consider sinking your dollars in a safer mutual fund such as a money market fund or bond fund.
How Much Is The Expense Ratio?
When you invest in a mutual fund, part of your dollars will go toward covering its expense ratio. Basically, this is the money your mutual fund company charges to run the fund. As its name suggests, the expense ratio pays for the expenses involved in operating a mutual fund (which includes everything from the salaries of analysts to monthly office leases).
When comparing mutual funds, look at the expense ratios. If one fund charges an expense ratio of 1%, another charges 0.5% and both funds are otherwise equal, it makes more sense to invest with the one that charges a lower expense ratio.
Find The Fund That Matches Your Philosophy
Are you more interested in investing in the stock of companies that have the potential to grow quickly, or are you more interested in companies that have an established track record even if their growth might be slower? Make sure you invest with a fund that follows your philosophy.
No-Load Funds Are A Better Value
Do you remember the difference between no-load and load funds? In load funds, you pay a fee to the person or company that sells you the mutual fund. No-load funds don’t charge these fees. Again, it’s usually smarter to invest in a mutual fund that does not charge these upfront fees unless you are paying for analysts with a long record of picking winning securities.
Pros And Cons Of Investing In Mutual Funds (FYI, It’s Mostly Pros)
Still not convinced? Here’s a handy chart listing the advantages and disadvantages of investing in mutual funds. After looking over the chart, you’ll find that the pros definitely outnumber the cons.
|Pros Of Mutual Funds||Cons Of Mutual Funds|
|· Diversity: When you put your money in a mutual fund, it’s dispersed among a variety of investment vehicles. This reduces the risk of such an investment.
· Professionals: Your fund will be managed by a financial professional. This is a good choice for investors who don’t want to spend long hours researching possible investments.
· Affordable: Many mutual funds are inexpensive. No-load funds especially allow you to invest without spending a ton of money.
· Variety: You can choose from a range of mutual fund products, which includes everything from riskier equity funds to safer money market versions.
|· NO FDIC insurance: The biggest drawback to mutual funds is that your investments aren’t insured by the Federal Deposit Insurance Corporation (FDIC). This means that you have no protection should your investments suffer big drops in value.
· Not as much control: You give up control over how your dollars are invested when you participate in a mutual fund. Instead, the fund manager decides which stocks, bonds and other investment vehicles to buy.
· Fees: It costs money to run a mutual fund. Part of your investment will go toward covering these fees.
The Takeaway: Are Mutual Funds Right For You?
All investments have advantages and disadvantages. Of course, you know this. However, you probably still want to know: do the advantages of mutual funds outweigh the disadvantages?
The answer to this question depends on how comfortable you are with risk, what your investing goals are and how involved you want to be in your investments.
With mutual funds, you can take on as much risk as you do or don’t want. If you’re risk-averse, you can invest in a more conservative fund. If you don’t mind some risk, you can work with funds that invest in more volatile stocks.
If you need your investments to show a strong return quickly, you might invest in one of the riskier mutual fund types. If you can afford to be patient and you’re saving for the long haul, you can invest in a fund that has higher risk and wait out these risks. Otherwise, you can work with a more conservative fund and enjoy the steadier (but slower) growth.
One more time: Should I invest in a mutual fund?
We can’t answer that for you. But we can tell you that, if handled correctly, mutual funds can be a great way to grow your wealth.
We know investing may seem like a daunting task initially, but investments can have great long-term benefits for your financial health.
If you learn everything you can, invest wisely and understand the risks involved in each investment, your financial future can be bright. Remember, everyone’s financial situation is different. It’s best to talk to a licensed financial professional before making any major financial decisions.
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