How to Make Money by Investing in Mutual Funds

Understanding How Mutual Funds Generate Cash

Making money investing in mutual funds isn't like making money from other investments because how you earn a profit depends upon the underlying investments held by your fund.
Making money investing in mutual funds isn't like making money from other investments because how you earn a profit depends upon the underlying investments held by your fund. Steve Debenport/Getty Images

Americans have invested in mutual funds through their 401(k) plan at work, their Roth IRAs, their Traditional IRAs, their 403(b)s, their SEP-IRAs, their SIMPLE IRAs, or any other types of retirement accounts, so much so that they represent a vast proportion of the assets held within them.  Unfortunately, many new investors, as well as countless retirement account holders, can't actually tell you what a mutual fund is, how a mutual fund works, or how someone actually makes money from owning a mutual fund.

  In this brief introduction, I hope to change that by answering some of those questions.

What are Mutual Funds?

Before you can understand how investors make money investing in mutual funds, you have to understand what a mutual fund is and how it generates profits.  Start by reading The New Investor's Guide to Mutual Fund Investing, which is an extensive resource I put together to help you learn all about mutual funds. In particular, you may want to read How a Mutual Fund Works.  However, if you're pressed for time, here's the condensed definition.

Simply stated, a mutual fund is a term used to describe a type of company that doesn't do anything itself, but rather it owns investments.  The company, which is the mutual fund, hires a portfolio manager and pays him or her a management fee, which often ranges between 0.50% and 2.00% of assets.  The portfolio manager invests the money raised by the fund according to the strategy laid out in a document called the mutual fund prospectus.

Some mutual funds specialize in investing in stocks, some in bonds, some in real estate, some in gold. The list practically goes on and on with mutual funds organized for nearly every type of investing strategy or niche you can imagine.  As I mentioned in Making Money Investing in Dividend Stocks, 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 objective you may wish to achieve.

How Mutual Funds Can Make Money For You

The type of mutual fund in which you invested will determine how you generate cash.  If you own a stock fund, you already learned in Making Money from Investing in Stocks 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 distributed profits.  If the fund focuses on investing in bonds, you might be making money through interest income.  If the fund specializes in investing in real estate, you might be making money from rents, property appreciation, and profits from business operations, such as vending machines in an office building.

The Three Keys to Making Money Through Mutual Fund Investing

There are three major keys to making money through mutual fund investing. These are:

  1. Only Invest in Mutual Funds You Understand
    If you can't explain, quickly, succinctly, and with specificity, exactly how a mutual fund invests, what its underlying holdings are, what the risks of the mutual fund's investment strategy are, and why you own a particular mutual fund, you probably shouldn't have it in your portfolio.  It's much easier to measure, contain, and appreciate risk when you keep things simple.
  1. Think In Periods of 5 Years or More
    It's much easier to let your wealth compound if you can ride out the sometimes sickening waves of market volatility that is part and parcel of investing in stocks or bonds.  If you own, say, an equity mutual fund, be prepared for it to decline by 50% in any given year.  These things happen.  Presuming you've drawn up a well-researched, sound plan based on common sense, basic mathematics, and prudent risk management strategies, allowing yourself to become emotional and selling your productive assets at the worst possible time is not likely to cause you to build long-lasting generational wealth.
  2. Pay Reasonable Expenses
    Apart from the mutual fund's expense ratio, it is also important to consider a handful of other costs.  Tax efficiency matters.  Income needs matter.  Risk exposure matters.  All need to be weighed against each other and other relevant factors.  The point is to make sure you are getting value for what you pay.

    Please note that The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.