If you are like millions of people, you own a mutual fund investment and don’t understand its investment basics. What is a mutual fund, how does it work, what kinds are there, and who should invest money in a mutual fund? Here are the investment basics.
A mutual fund is a pool of investor money that is professionally managed for its investors as an investment portfolio. These funds are regulated by the government to protect investors against fraud or other abuses.
You can invest money in a mutual fund in a lump sum, like $10,000, and this buys you shares based on the current net asset value or share price. Or, as millions of Americans do, you can invest periodically like in a 401k plan, IRA, or other account. The investment basics from your perspective: You then own a small part of a large investment portfolio of securities and can make money in two basic ways. The value or price of your shares can go up, and your fund might pay income in the form of dividends which are usually automatically reinvested for you to buy more fund shares.
The investment basics from the mutual fund company’s point of view: they make money by taking assets out of the fund periodically to pay for management and other expenses, and to provide themselves with a profit. This usually amounts to less than 2% of assets a year and can be as little as ½% or less. The larger the pool of assets in the investment portfolio, the more money the mutual fund company makes. Hence, the fund company tries to keep investors happy with good performance, because investors can pull money out of a mutual fund as easily as the can invest money.
Now let’s get down to investment basics in terms of the kinds of funds offered based on where they invest your money. There are three traditional types of funds: equity or stock funds (same thing), bond funds and money market funds. Plus there are many combinations and variations of each of the above. Equity funds invest in stocks and have the greatest profit potential with the heaviest risk. The objective is growth and perhaps some dividend income. Bond funds pay the highest dividend income to investors, from the interest earned from the bonds held in the portfolio. Investment risk is usually moderate.
Generally speaking, equity fund share prices fluctuate significantly and bond fund share prices fluctuate moderately most of the time. That said, the investor should be aware of the fact that either mutual fund investment can be expected to produce losses from time to time. The safest mutual fund type is a money market fund, and losses are rarely an issue here. These funds earn interest for investors by investing in safe (short-term) money market securities. The dividends they pay vary with prevailing interest rates, and the share price is pegged at $1 and does not fluctuate.
Who should invest money in a mutual fund? Anyone who is in a position to invest and wants to get ahead; but doesn’t have the time, experience or inclination to manage an investment portfolio on their own should. The real investment basics of mutual fund investing are that these funds were designed for average investors. In their present form they have been popular and have served investors well for over 40 years.