Investing in Mutual Funds 101

For a large number of individual investors, mutual funds are the easiest and most effective way to start generating capital.

In fact, a greater amount of investors are utilizing mutual funds as a way to build wealth off of investments than ever before. Since mutual funds are so effective, more and more investors are interested in learning about the advantages and risks of that type of investment. It is essential that all investors do some research and learn about mutual funds before they first invest their money.

How do mutual funds work?

A mutual fund is a pool of different stocks, bonds and other investments that are all handled by a professional fund manager. Typically, these types of investments will gather a collection of money from multiple different investors. By doing so, these investors will have greater purchasing power as a collective than they would if they were to invest on their own. Each investor in a mutual fund owns a share of the fund, which essentially means that they have investments in many different stocks, bonds and other assets. The cost of each share depends on the fund’s net asset value (NAV), which takes into account the value of the portfolio and subtracts the cost of liabilities. Mutual funds hold many benefits for investors, but there are also a fair share of limitations and disadvantages to consider.

After investing money into a mutual fund, your finances will be pooled along with the money of other investors in a collection of assets. This collection is often referred to as the portfolio for a mutual fund. The types of stocks, bonds and other assets that are chosen for a portfolio will be carefully selected by a professional fund manager. This professional fund manager will be responsible for researching companies and analyzing market conditions while they manage the money from all of the investors. Using this information, the professional fund manager will make the best investment decisions based on the financial goal of the mutual fund.

How can you make money from mutual funds?

When you invest in a mutual funds, you can make money in a few different ways. The three main methods of generating a profit from mutual funds include:

  1. Redeeming your shares at a higher net asset value (NAV).
  2. Receiving dividends on any bonds or similar investments in the portfolio.
  3. Receiving capital gains distributions from profitable stocks.

Different Types of Mutual Funds

Since mutual fund portfolios are made up of numerous different investments, each mutual fund can be different. However, most mutual funds can be categorized as one of four types of investments. The general categorizations for mutual funds include:

  • Equity funds – These are mutual funds where most of the investments are made with stocks. Equity funds can sometimes be referred to as stock funds.
  • Fixed-income funds – Mutual funds majority of the investments are made with bonds from business or governments are called fixed-income funds. Since bonds are typically low-risk investments, fixed-income funds are usually safer than equity funds.
  • Money market funds – These types of mutual funds are generally the safest investments that professional fund managers can make. Money market funds invest solely in cash or cash equivalent securities, which have a high credit quality and they are very likely to pay back the short-term investments.
  • Balanced funds – Balanced funds usually consist of a combination of stocks and bonds and are sometimes referred to as hybrid funds. These mutual funds offer investors a combination of income, security and capital gain.

Benefits of Mutual Funds

New investors will often find that mutual funds hold many advantages, which can make them a great option for getting into investing. One feature that makes mutual funds so appealing to new investors is the benefit of having a professional fund manager handling their investments. Since professional fund managers have experience and are dedicating their time to researching companies, analyzing the market and making investments, they can be helpful for new investors. Investors who are short on time, experience or resources will also often prefer to put their finances into mutual funds. Mutual funds are a great way to enter into the world of investing.

Investing in a mutual fund means that your money will be distributed across dozens, and sometimes even hundreds, of individual securities from a variety of different companies and industries. Mutual funds are helpful because they distribute the risk across a variety of different investments, which lowers the chances of any one investment failing and causing a huge financial loss. Additionally, mutual funds typically trade in larger amounts of assets which results in a smaller transaction fee than investing individually.

Disadvantages of Mutual Funds

Although there are many benefits of investing in mutual funds, there are also a few drawbacks and risks that investors should take into account. For example, almost all investors in mutual funds are required to pay for the cost of organizing, distributing and managing a fund. Typically, investors will pay these costs in the form of fees such as transaction charges and redemption costs. Investors are recommended to speak with their professional fund manager about any fees and additional costs before they agree to invest their money.

Additionally, like all investments, mutual funds naturally have the possibility of loss in the financial market. If the assets in a mutual fund portfolio drop in value, investors could end up losing money on their investment. Although mutual funds reduce this risk by investing money in a diverse range of assets, the risk of loss will always exist. Another disadvantage of mutual funds comes as a result of the diversified assets. Any excessive diversification could lead to low returns on mutual fund investments, so it is essential that professional fund managers consider this possibility.

Fortunately, investing in mutual funds continues to be an effective investment strategy despite the potential risks. Although investors are putting in less money individually, the collective pool of investments gives everyone more buying power. With the right professional fund manager, mutual funds can be a great way for investors to grow their finances.