Of course you’ve heard of mutual funds, and maybe what your friends have told you about how they work, their fluctuations, and the ways they help you accrue wealth as an investor. But now that you are ready to plunk down your first dollars into an initial investment, having a good understanding of mutual funds, how they operate, and their related costs will help you through your journey as an informed investor.

Definition

A mutual fund is an investment that uses pooled money from you and other investors to make investments in an array of companies. An individual share of the mutual fund represents your ownership stake in the fund.

As an individual investor, you can look at a mutual fund as a way of balancing risk through diversification that may require a large amount of investment capital.

Process

A fund manager and possibly a team of analysts will make investments in shares of stock of various companies or asset classes. Although every fund management strategy is different, the basic idea is to balance earning and loss potential of various asset classes based on their performance, the industry to which they are related, or other factors that can alter security values.

Profits (i.e.: why you would shoulder risk in Mutual Funds in the first place)

The Ohio State University (OSU) Department of Family and Consumer Science delineates three ways you profit from mutual funds as an investor. First, depending on the type of mutual fund in which you invest, the fund will gain income through interest paid from bond ownership, or dividends from stocks (see “Mutual Fund Breakdown”). This income is then passed onto shareholders and may be taxable.

Additionally, investment of stocks or bonds in the mutual fund you joined may increase in value. Should those assets be sold, the funds obtain a capital gain. Capital gains are distributed to fund shareholders after capital losses are deducted. Much like income, capital gains are passed to shareholders, and are always taxable.

Finally, OSU notes that when a fund does not pass income or gains to its investors and retains earnings in the fund, the value of the shares increase. This growth, known as Net Asset Value (NAV), gives individual investors the option of selling their shares for a profit in which the gains will be taxed in the year of the sale.

Points to Consider

Since there are thousands of mutual funds in which you can invest, there are some basic points you should consider as you evaluate various mutual funds:

• Performance: What has the firm given to its shareholders in terms of profits?
• Risk: With your risk tolerance in mind, what is the risk level of the fund--is it aggressive or conservative? Does it match your investment goals and risk tolerance?
• Costs: What are the fees associated with investing in a particular fund? When are the fees taken from your investment?

You’re not done yet. Please see “Mutual Fund Breakdown” for categories and types of standard and specialized funds. Additionally, see “Mutual Funds: What are my Costs?” to understand the fees and taxes that may be associated with profits derived from mutual funds.

Keep in mind that no investments are insured or guaranteed, and there are no strategies that will always ensure returns on investment. Additionally, everyone has a certain level of risk tolerance that will affect their decision making. If you are unsure, you can talk to investment professionals for advice on your investment goals.

References


Westcore Funds. Mutual Funds Basics

Ruth Anne Mears. Start With Mutual Funds

money.howstuffworks.com. How Do Mutual Funds Work