The Basics of Mutual Fund Investing
Investing in Stocks, Bonds and Securities
Mutual Funds is a way to invest in stocks, bonds and securities.
Mutual funds are managed by professional money managers.
By owning shares in a mutual fund instead of buying individual stocks or bonds directly, your investment risk is spread out.
Because your mutual fund buys and sells large amounts of securities at a time, its costs are often lower than what you would pay on your own.
This article explains the basics of mutual fund investing — how a mutual fund works, what factors to consider before investing, and how to avoid common pitfalls.
There are sources of information that you should consult before you invest in mutual funds. The most important of these is the prospectus of any fund you are considering. The prospectus is the fund's selling document and contains information about costs, risks, past performance, and the fund's investment goals. Request a prospectus from a fund, or from a financial professional if you are using one. Read the prospectus before you invest.
Before you buy a mutual fund, make sure it is right for you.
How Mutual Funds Work
A mutual fund is a company that brings together money from many people and invests it in stocks, bonds, or other securities. (The combined holdings of stocks, bonds, or other securities and assets the fund owns are known as its portfolio.) Each investor owns shares, which represent a part of these holdings.
How To Buy and Sell Shares
You can buy some mutual funds by contacting them directly. Others are sold mainly through brokers, banks, financial planners, or insurance agents. All mutual funds will redeem (buy back) your shares on any business day and must send you the payment within seven days.
You can find out the value of your shares in the financial pages of major newspapers; after the fund's name, look for the column marked "NAV." Many mutual funds also provide a website where investors can access complete information about their portfolio.
Net Asset Value e (NAV)
Net Asset Value per share (NAV) is the value of one share in a fund.
When you buy shares, you pay the current NAV per share, plus any sales charge (also called a sales load). When you sell your shares, the fund will pay you NAV less any other sales load. A fund's NAV goes up or down daily as its holdings change in value.
Example: You invest $1,000 in a mutual fund with an NAV of $10.00. You will therefore own 100 shares of the fund. If the NAV drops to $9.00 (because the value of the fund's portfolio has dropped), you will still own 100 shares, but your investment is now worth $900. If the NAV goes up to $11.00, your investment is worth $1,100. (This example assumes no sales charge.)
How Funds Can Earn You Money
You can earn money from your investment in three ways.
First, a fund may receive income in the form of dividends and interest on the securities it owns. A fund will pay its shareholders nearly all of the income it has earned in the form of dividends.
Second, the price of the securities a fund owns may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors.
Third, if a fund does not sell but holds on to securities that have increased in price, the value of its shares (NAV) increases. The higher NAV reflects the higher value of your investment. If you sell your shares, you make a profit (this also is a capital gain).
Usually funds will give you a choice: the fund can send you payment for distributions and dividends, or you can have them reinvested in the fund to buy more shares, often without paying an additional sales load.
Taxes on Mutual Funds
You will owe taxes on any distributions and dividends in the year you receive them (or reinvest them). You will also owe taxes on any capital gains you receive when you sell your shares. Keep your account statements in order to figure out your taxes at the end of the year.
If you invest in a tax-exempt fund (such as a municipal bond fund), some or all of your dividends will be exempt from federal (and sometimes state and local) income tax. You will, however, owe taxes on any capital gains.
Kinds of Mutual Funds
You take risks when you invest in any mutual fund. You may lose some or all of the money you invest (your principal), because the securities held by a fund go up and down in value. What you earn on your investment also may go up or down.
Each kind of mutual fund has different risks and rewards. Generally, the higher the potential return, the higher the risk of loss.
Before you invest, decide whether the goals and risks of any fund you are considering are a good fit for you. To make this decision, you may need the help of a financial adviser. There are also investment books and services to guide you.
The three main categories of mutual funds are money market funds, bond funds, and stock funds. There are a variety of types within each category.
1. Money Market Funds have relatively low risks, compared to other mutual funds. They are limited by law to certain high- quality, short-term investments. Money market funds try to keep their value (NAV) at a stable $1.00 per share, but NAV may fall below $1.00 if their investments perform poorly. Investor losses have been rare, but they are possible.
2. Bond Funds (also called Fixed Income Funds) have higher risks than money market funds, but seek to pay higher yields. Unlike money market funds, bond funds are not restricted to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.
Most bond funds have credit risk, which is the risk that companies or other issuers whose bonds are owned by the fund may fail to pay their debts (including the debt owed to holders of their bonds). Some funds have little credit risk, such as those that invest in insured bonds or U.S. Treasury bonds. But be careful: nearly all bond funds have interest rate risk, which means that the market value of the bonds they hold will go down when interest rates go up. Because of this, you can lose money in any bond fund, including those that invest only in insured bonds or Treasury bonds.
Long-term bond funds invest in bonds with longer maturities (length of time until the final payout). The values (NAVs) of long-term bond funds can go up or down more rapidly than those of shorter-term bond funds.
3. Stock Funds (also called Equity Funds) generally involve more risk than money market or bond funds, but they also can offer the highest returns. A stock fund's value (NAV) can rise and fall quickly over the short term, but historically stocks have performed better over the long term than other types of investments.
Not all stock funds are the same. For example, growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains. Others specialize in a particular industry segment such as technology stocks.
Banks and Mutual Funds
Banks now sell mutual funds, some of which carry the bank's name. But mutual funds sold in banks, including money market funds, are not bank deposits. Don't confuse a "money market fund" with a "money market deposit account." The names are similar, but they are completely different:
A money market fund is a type of mutual fund. It is not guaranteed, and comes with a prospectus.
A money market deposit account is a bank deposit. It is guaranteed, and comes with a Truth in Savings form.
A Word About Derivitives
Some funds may face special risks if they invest in derivatives. Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security or index. Their value can be affected dramatically by even small market movements, sometimes in unpredictable ways.
There are many types of derivatives with many different uses. They do not necessarily increase risk, and may in fact reduce risk. A fund's prospectus will disclose how it may use derivatives. You may also want to call a fund and ask how it uses these instruments.
Comparing Different Funds
Once you identify the types of funds that interest you, it is time to look at particular funds in those categories. Viewing Past Performance
A fund's past performance is not as important as you might think. Advertisements, rankings, and ratings tell you how well a fund has performed in the past. But studies show that the future is often different. This year's "number one" fund can easily become next year's below average fund. (NOTE: Although past performance is not a reliable indicator of future performance, volatility of past returns is a good indicator of a fund's future volatility.)
Tips For Comparing Performance
Check the fund's total return. You will find it in the Financial Highlights, near the front of the prospectus. Total return measures increases and decreases in the value of your investment over time, after subtracting costs.
See how total return has varied over the years. The Financial Highlights in the prospectus show yearly total return for the most recent 10-year period. An impressive 10-year total return may be based on one spectacular year followed by many average years. Looking at year-to-year changes in total return is a good way to see how stable the fund's returns have been.
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