People invest in mutual funds through their 401(k) plan at work, IRAs, 403(b)s, SEP-IRAs, SIMPLE IRAs, and other types of retirement accounts. Mutual funds make up a large part of the assets held in retirement accounts.
Still, many people who are invested in them may not be able to tell you what mutual funds are, how they work, or how you earn money from owning them.
- A mutual fund contains a group of investments. Some specialize in stocks, bonds, real estate, or gold.
- The type of mutual fund you have your money in will determine how you earn income with it.
- When you invest in mutual funds, it's a good idea to only invest in funds you understand.
- When you have a mutual fund, think in periods of five years or more, and don't focus on the daily ups and downs of the market.
Mutual Funds Defined
To understand how investors make money in mutual funds, you should know what a mutual fund is and how it creates profits.
Simply stated, mutual fund is a term used to describe a fund that owns a group of investments. The fund's company hires a portfolio manager for the fund, who is paid a fee for managing it. The pay often ranges between 0.50% and 2.00% of the fund's assets. The fund manager invests the money raised by the fund according to the strategy laid out in a document called the mutual fund prospectus. This document must be given to people who have money in the mutual fund on a yearly basis, but they should read it before putting any money into a fund.
In the fund's prospectus, you'll learn about its goals, fees, risks, fund shares, investments, how it performs, and much more.
Some of these funds invest in stocks, some in bonds, some in real estate, some in gold. There are mutual funds at work for nearly every type of investing strategy or niche you can imagine. There are even funds designed for people who only want to own dividend stocks in the S&P 500 that have increased the dividend every year for the past 25 years. It is safe to say that there is a mutual fund for almost any niche or investing goal you may wish to achieve.
Mutual Funds and Making Money
The type of mutual fund in which you invest will decide how you earn from it. If you own a stock fund, you may have found that the biggest sources of potential profit are an increase in the stock price (capital gains) or cash dividends paid to you for your pro-rata share of the company's profits.
If the fund is focused on investing in bonds, you might be making money through interest income. If the fund invests in real estate, you might be making money from rents, property appreciation, and profits from business operations.
Three Keys to Making Money
There are three major keys to making money through mutual fund investing. These are:
- Only invest in mutual funds you know about: You should be able to explain, with ease, how the fund invests. If you can't tell other people how the fund works, what some of its major holdings are, the risks of its strategy, and why you own it, you probably shouldn't have it in your portfolio. It's much easier to measure and contain risk when you keep things simple and know how they work.
- Think in periods of five years or more: It's much easier to let your wealth grow if you can ride out the at times crazy waves of market volatility that is part and parcel of investing in stocks or bonds. If you own, say, an equity fund, be ready for it to decline by 50% in any given year. These things happen. If you've drawn up a well-researched, sound plan based on common sense, basic math, and smart ways of dealing with risk, you need to stay the course. Letting your emotions or fear take over and selling your fund assets at a bad time in the market is not the way you'll build long-lasting, generational wealth.
- Pay reasonable costs and fees: Apart from the mutual fund's expense ratio, it is also vital to think about a handful of other costs. Tax efficiency matters. Income needs matter. Risk exposure matters. All of these factors need to be weighed against each other and other relevant issues. The point is to make sure you are getting value for what you pay.