A mutual fund is a pool of money, supplied by investors like you, that is usually invested in stocks, bonds, and/or money market instruments. Each fund has a professional manager or a team of managers making day-to-day and minute-by-minute buy and sell decisions.
By pooling your resources with other investors in a mutual fund, you can reduce—but not totally eliminate—risk. If you further diversify by purchasing shares of more than one type of mutual fund, your risk is reduced even more. Also, since fund managers buy and sell large blocks of securities, the costs are often lower than what you would pay on your own.
Some fund companies will sell shares directly to investors. Others are sold through brokers, online brokerages, banks, financial planners, and insurance agents who are registered to sell mutual funds. In most cases, you can sell your mutual fund shares at any time, but certain withdrawal charges may apply. Generally, mutual funds are considered long-term investments (five or more years).
Good Reasons to Invest in Mutual Funds
- Professional managers have more experience than the average investor and managing the fund is their job.
- A variety of funds are available, including stock, bond, and money market mutual funds.
- Funds, while riskier, may provide more growth than fixed rate instruments. Mutual funds, however, are not federally insured and may lose value.
- You won’t have all your eggs in one basket. Mutual funds are diversified (i.e., they represent a wide variety of investments) to help protect against the failure of one of the underlying securities. Keep in mind there is no guarantee that a diversified portfolio will outperform one that is not diversified.
- Most mutual funds are liquid, meaning they are easily turned into cash. You can arrange to sell your shares at the current Net Asset Value (NAV), which is the daily market value of the fund’s total investment portfolio divided by the number of outstanding shares.
Drawbacks to Mutual Funds
- Funds are not risk-free. It is possible that you could lose money since mutual fund shares are usually shares in stock and/or bond portfolios and are not guaranteed.
- Distributions are taxable. You will owe taxes on any dividend or capital gain distributions from the fund portfolio in the year they are received—even if the distribution is reinvested.
- There are fees and expenses. Most fund companies impose sales charges, called “loads.” Other charges, like redemption fees; advertising and distribution fees (see page 3); low-balance account fees; and custodial bank fees can also be imposed. Check with the fund company to find out what kinds of fees you can expect.
How Mutual Funds May Help You Make Money
Capital appreciation occurs when you sell shares for a price higher than you paid for them. The profit you realize is called capital appreciation.
Dividends are a payout of a portion of a company’s earnings to stockholders. Mutual fund earnings come from dividend-paying stocks and income-producing bonds held in the fund’s portfolio. As a shareholder, these dividends are passed on to you. You may reinvest dividends or receive them in cash.
Capital gain distributions. When stock in a fund portfolio is sold at a gain, the profit is passed on to fund shareholders as a capital gain distribution. As with dividends, you may either reinvest the distribution or receive it in cash.
