Summary of video: Investing Basics: What are Mutual Funds?
Mutual funds are the easy way to invest because for a very low cost investors can own a share of an extremely diverse portfolio of stock, or bonds, or both. You pay an annual fee for the fund management (and smart investors find index funds where this is very low). One way that investors make money is if the stocks in the fund appreciate. The second way is through a dividend payment.
Transcript of Investing Basics: What are Mutual Funds?
A mutual fund is a collective investment that pools together the money of a large number of investors to purchase a variety of securities—like stocks or bonds. When you purchase a share in a mutual fund you have a small stake of all investments included in that fund.
Think of a mutual funds like a basket of investments. When you purchase a share in a mutual fund you are buying one share of this basket, and therefore have a stake in one small fraction of all the investments in that fund.
Mutual funds can benefit investors in several ways. They are simple way to make a diversified investment. Most are managed by a financial professional. And because of the wide variety of mutual funds, they allow investors to participate in a wide variety of investments.
Let’s walk through an example of how a mutual fund works. Suppose there’s an investor who wants to invest some of his retirement portfolio in the stock market, but he doesn’t have time to analyze individual stocks and create a diversified stock portfolio. Instead, he decided he’d rather purchase a mutual fund. This way, the investor can purchase a single investment which will, in effect, be similar to purchasing an entire portfolio of stocks.
Which mutual fund is right?
But which mutual fund is right for him?
To find the right one, he uses online tools such as mutual fund searches and ratings given by independent third party organizations, to find a mutual fund that meet his investing goals. Once he finds a fund that looks like a good fit, he reviews the fund’s prospectus, which is the official summary and explanation of how the fund operates.
The prospectus provides a wide variety of information about the fund including its fees and charges, minimum investment amounts, performance history, risks and other useful information.
After researching the fund and its prospectus, our investor decides that this fund looks like a good investment so he pays the minimum investment amount and purchases one share of the mutual fund.
By owning a share, the investor now participates in the gains and losses of all companies held in the fund. The benefit of this is diversification, which is when an investment or portfolio is spread across several different investments. Doing this helps lower risk. For example, if one company that the fund invests in has a rough year, the impact on the fund’s total assets can be small because that struggling company is only one fraction of the fund’s total assets.
Like most other mutual funds, the fund the investor chose is actively-managed—meaning it is run by a fund manager, or managers, who buy and sell the fund’s assets. Managers work to provide the biggest returns they can for investors using financial analysis and professional expertise.
While a talented manager could earn good returns for the investor’s fund, there is no guarantee of success. If a manager makes choices that don’t pay off, our investor won’t earn the returns he was hoping for. However, even if the fund doesn’t perform well, the manager still collects a fee which is paid from fund assets—meaning even lower returns.
Management fees aren’t the only costs our investor has to pay either. Besides transaction fees, the Fund may have a sales load which is a charge to either buy or sell shares. Some funds also charge an additional load shares are sold within a specific time frame.
How do you make money from a mutual fund?
Now that the investor has bought into a fund, how does he make money from it?
The first way is through appreciation, which is when the fund shares go up in value. Typically when the fund’s assets rise in value, the fund shares do the same. Unlike a stock, the value of a fund’s shares does not change throughout the trading day. Instead, the fund’s value is calculated and updated when the market closes.
The second way to make money through mutual funds is through a dividend payment, which is when a mutual fund pays out a portion of its earnings to shareholders. However, when the fund’s assets fall in value, the fund shares do the same, which is a risk of owning a mutual fund.
One benefit to mutual funds is the variety of mutual funds available. Our investor chose a mutual funds that invested in stocks. However there’s a mutual fund for almost every type of investment. For example, equity funds buy stocks. Fixed-income funds buy bonds. And balanced funds buy both.
Index funds own the whole market and lowest costs
Some equity mutual funds may invest in a whole index, while some others focus on stocks of a certain country or market sector.
Certain funds have different objectives as well. Some may look for riskier stocks in growing industries, while others will invest in more stable companies. There’s a lot to learn about mutual funds and other investment options and we’ve got the resources to help you get started . . .
