The Basics of Mutual Funds
What They Are and How They Can Make You Money
A mutual fund is a pool of money provided by individual investors, companies, and other organizations, and is one of the easiest and least stressful ways to invest in the market. A fund manager is hired to invest the cash the investors have contributed, and the fund manager's goal depends on the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk. A long-term growth manager, on the other hand, should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year, although very few funds achieve this.
As part of our Complete Beginner's Guide to Investing in Mutual Funds special, this article can give you the foundation you need to start understanding mutual fund investing.
Closed vs. Open-Ended Funds
Mutual funds are divided into closed-end and open-end funds, and the latter is subdivided by load and no load. Closed-end funds have a set number of shares issued to the public through an initial public offering. Because these shares trade on the open market and closed-end funds don't redeem or issue new shares like a typical mutual fund, the fund shares abide by the laws of supply and demand and normally trade at a discount to the net asset value.
A majority of mutual funds are open-ended, meaning that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.
A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund's shares. No-load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.
Benefits of Investing in a Mutual Fund
Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is their primary occupation, they can devote considerably more time to selecting investments than an individual investor. It provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.
Selecting a Fund
Every fund has a particular investing strategy, style, or purpose. Some, for instance, invest only in blue-chip companies, while others invest in start-up businesses or specific sectors. Finding a mutual fund that fits your investment criteria and style is vital; if you don't know anything about biotechnology, you probably shouldn't be investing in a biotech fund. You must know and understand your investment.
After you've settled on a type of fund, turn to Morningstar or Standard & Poor's (S&P) for more information. Both of these companies issue fund rankings based on past records. You must take these rankings with a grain of salt, though; past success is no indication of the future, especially if the fund manager has recently changed. If you already have a brokerage account, you can purchase mutual fund shares as you would a share of stock. If you don't, you can visit the fund's web page or call them and request information and an application.
While some funds don't have a minimum initial investment, most funds have a minimum initial investment, which can be as low as $25 or as high as $100,000. The minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account—like a 401k, traditional IRA, or Roth IRA—or the investor agrees to automatic, reoccurring deductions from a checking or savings account to invest in the fund.
The Importance of Dollar-Cost Averaging
The dollar-cost averaging strategy is used to offset the negative impacts of market volatility by spreading out when you buy mutual fund shares into intervals, purchasing approximately the same amount each time. For example, instead of putting $4,000 into a mutual fund at once, you may decide to put in $1,000 every quarter.
This strategy helps to ensure you don't dump large amounts of money into a mutual fund while the price point is high or overvalued, and it is just as applicable to mutual funds as it is to common stock. Establishing such a plan can substantially reduce your long-term market risk and result in a higher net worth over a period of 10 years or more.