Mutual funds are a collection of investments. You pool your money with other investors to buy stocks, bonds, and other assets.
What’s a mutual fund?
Mutual funds are collections of stocks, bonds, or other assets that you purchase by pooling money with other investors.
Related: How to invest in index funds
Purchasing individual stocks can be expensive, which is why mutual funds are appealing. You can own a portfolio of securities without paying for each one at full price. You also won’t have direct ownership of a company because you’re buying a fund that owns the shares.
The price of a mutual fund is known as the net asset value (NAV) per share. It’s determined by the total value of stocks, bonds, and other assets in the portfolio. Then, it’s divided by the number of outstanding shares.
Related: How to read a stock chart
Mutual funds are a low-cost way to own a diverse portfolio of securities. It’s also used to reduce risk and provide steady returns. It’s designed to be a long-term investment, which experiences compounding growth over the years.
When you invest in a mutual fund, you’re not buying and selling the assets on your own. Instead, professional managers take care of the fund and make the trades. The fund managers do their best to produce gains and profits for the investors.
Related: How much should I contribute to my 401(k)?
How it works
You can purchase shares of a mutual fund through different investment companies. Fidelity, Vanguard, Charles Schwab, BlackRock, Invesco, and T. Rowe Price are all examples of companies that offer mutual funds. Before you begin investing in them, learn exactly how it works.
First, companies that manage mutual funds must register with the Securities and Exchange Commission (SEC). The SEC protects investors and maintains fair, orderly, and efficient markets.
Then, the company pools money from investors to purchase stocks, bonds, other securities, and assets. This is known as the portfolio. It’s managed by one or multiple fund managers who are also registered with the SEC.
For your protection and the legitimacy of the fund, it’s important to make sure that the company and managers are registered with the SEC.
Every share that you own is your percentage in the ownership of the fund. While you don’t own the individual stocks that the fund managers buy, you’re entitled to profits. Some mutual funds also pay dividends.
Another way that you can make money with mutual funds is by selling your shares when the price of the mutual fund increases. This is known as capital gains.
The diverse portfolio and professional management do come at a cost. While there’s a wide range of potential costs, it’s important to find a professional that’ll help you evaluate a fund that performs well and has reasonable fees.
Fees that you may encounter include operating expenses, professional management, commissions, transaction fees, and other costs of running a fund.
Typically, you’ll see the fees listed under the expense ratio. It’s the annual percentage that the fund charges you to cover the expenses. It’s also taken out of the returns, which means you won’t be paying it from your bank account.
Look for low-cost mutual funds that have a good reputation for their performance. It’s a long-term investment, which means you must go into it with a buy-and-hold mentality.
Types of mutual funds
With all of the different investment companies, strategies, and markets, there are many funds to choose from. The following are the different types of mutual funds and what they mean:
- Equity or stock funds. Invests primarily in stocks. They’re commonly called small-cap, mid-cap, or large-cap funds.
- Fixed-income or bond funds. Invests primarily in bonds, which also means it comes with less risk than equity funds.
- Index funds. A fund that mimics an index.
- Balanced funds. A blend of different assets to maximize gains while minimizing risk. It can be a mix of stocks, bonds, and other assets.
- International funds. Only invests in foreign assets.
- Income funds. A fund to provide a steady income. It’s popular among retirees.
- Money market funds. A risk-free fund to keep your money. It also leads to getting the lowest returns. Typically, it invests in T-bills.
- Specialty funds. A fund that’s focused on other assets and commodities, such as real estate.
All of the different types will fall into one of two categories, actively or passively managed funds.
Actively managed funds are designed to beat the market. The managers will aim to bring high returns, which also leads to more risk. Fees are also higher for actively managed funds because of how involved the managers are.
Passively managed funds are designed to follow an index, such as the S&P 500. They have lower fees because managers aren’t constantly trading, and the holdings will mimic what’s in the index.
If you’re willing to take on risk and don’t want to invest in individual stocks, mutual funds are an excellent option. When you buy shares of a mutual fund, you’ll have a diverse portfolio that aligns with your investing goals.
Your portfolio can be filled with many companies, bonds, and assets without paying for each security or asset individually. It’s a cost-effective way to invest.
Plus, fund managers will take care of all of the details. They have extensive knowledge of investing and the markets. So, you don’t have to spend time researching.
Another benefit of investing in a mutual fund is that you can buy and sell shares anytime. The liquidity is great because you can move money around easily.
While there are many upsides to mutual funds, there are also drawbacks. One big downside is that the returns may not be as high as investing in individual stocks.
If you invest in individual stocks, you may have the opportunity to make a lot more in profit. Plus, you’ll have ownership of the company. With a mutual fund, you don’t have ownership and your returns may be lower.
Another drawback is that you may be required to pay fees. Keep an eye on the expense ratio and any possible hidden fees because they can dig into your returns.
Frequently asked questions
Can you lose money in a mutual fund?
Yes, it’s possible to lose money when you invest in mutual funds. The gains and losses will depend on the type of investments you have, how they’re performing, the economy, and how it’s being managed.
Can I sell a mutual fund anytime?
As long as the market is open, you can buy or sell a mutual fund. If you place the order after hours or on the weekends, it’ll be executed when the market opens.
Do I pay taxes on mutual funds?
When you sell shares of a mutual fund, you’ll pay capital gains tax.
Investing in mutual funds gives you instant diversification at a low cost. It’s also good if you’re looking for a passive investing style. Since there are fund managers, you don’t have to worry about executing trades or picking assets.
Keep in mind that mutual funds typically don’t offer high returns compared to successful individual stocks. Diversification helps balance risk, though.
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About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.