10 Things You Should Know About Mutual Funds

Mutual funds are one of the most popular ways for new investors to build wealth. Whether you own them through your retirement plans, such as a 401(k) or IRA, or you buy them directly or through a brokerage account, this guide to mutual fund investing is designed to help you understand what they are, how they work, and things you may want to consider.

Mutual Funds 101

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It is first important to understand what mutual funds are. Mutual funds are a pot of money contributed by different investors and are managed by an individual or group.

Funds and other investment instruments are divided into shares. Shares are a portion of the fund itself. This is what you are purchasing when you invest in a fund—a share (or portion of a fund) that will grow or shrink in value with the value of the entire fund.

Mutual funds are divided into two types of funds—open and closed-ended. An open-ended fund does not have a limit on the number of shares that can be issued by the fund. A close-ended fund has a set number of shares, usually determined at the time of an initial public offering (IPO).

How a Mutual Funds Works

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Many investors wonder what is going on behind-the-scenes when they invest in a mutual fund. Much of the time, there is a board of directors or trustees that monitor the fund and make decisions based on shareholder interests.

There are many other agents involved in the management of a fund, such as accountants, auditors, and transfer agents. All of these entities receive payments for their roles in managing the fund.

Once you write a check to start investing, there is a process your funds follow. It is not absolutely necessary to understand all of the inner workings of mutual funds, but it helps to know how your money is handled. For beginners, this is an excellent look at how mutual funds are structured.

How Do I Buy Shares?

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Once you are ready to begin investing in mutual funds, you have to go about buying your mutual fund shares. There are three popular ways this is done in the United States. You have the option to purchase through a broker, a mutual fund company, or a retirement plan (either from your employer or a 401(k).

This overview will help you understand each of them, and some of the advantages certain methods have over others.

What Is a Sales Load?

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When you buy your first mutual fund, you may encounter something known as a sales load. There are front-end loads, back-end loads, deferred loads, and declining loads.

While this may sound complicated, it is very important that you understand what these terms mean. This is because buying the wrong type of mutual fund can take thousands or even tens of thousands of dollars directly out of your pocket in the form of commission payments.

Loads are a type of commission. If you are not fully aware of the load(s) your chosen fund has, you can potentially lose thousands of dollars.

Are Low-Cost Index Funds the Best Investment?

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Many professionals believe that low-cost index funds are a better investment choice for those who want to grow their wealth without a lot of hassle. How are index funds different? Should you consider investing in them instead of actively managed mutual funds?

Index funds are mutual funds based on the performance of one of the notable indexes (e.g., the S&P 500). Indexes are measurements of the performance of a select group of funds, and the index funds are designed to mirror the index's performance.

Index investments can be good investments if they fit your style and needs. This article discusses some key points for you.

10-Part Guide to Picking the Best Funds

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How do you pick the best mutual funds? There are more than a few initial considerations for you when picking mutual funds. Before you purchase any shares, you should know your risk tolerance, expense ratio, and have developed an investing philosophy (your reason for investing, how you invest, what you believe in).

This step-by-step guide illustrates some considerations and what to look for when building a mutual fund portfolio. It includes considering specific markets, such as energy or metals. It should be useful as you make your way through what can seem like an endless list of potential fund investments.

Don't Forget to Watch Out for a Huge Hidden Tax

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There is a little-known mutual fund tax that could cause you to owe massive amounts of money to the IRS even if you lose money investing in a mutual fund.

Mutual funds can become quite large over time. If there is an investment crisis, many investors will begin to dump their holdings, causing the widespread sale of larger investments to provide the cash needed to pay those investors who are cashing out. This triggers the capital gains tax, which can have devastating effects on investors.

Most new investors don't know how this works, or even how to spot this potential danger. Make sure you understand the risks involved with mutual fund taxes before considering mutual fund investing.

Don't Chase Past Performance

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While it may seem like a good idea to only buy shares of mutual funds that have good past performance, it is not safe to assume this. Mutual funds are a unique type of investment.

For example, portfolio managers change even though the fund name remains the same. If someone new is managing your money, you may not realize it.

Likewise, fund assets grow, making it more difficult to put money to work as the universe of potential investments shrinks.

Should I Invest in Bonds or a Bond Fund?

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Mutual funds aren't just for investing in stocks. A common question for beginners is whether new investors should own bonds or invest in a bond fund, which is a special type of mutual fund that owns bonds and other fixed-income investments.

Which type to invest in is largely dependant on how much you have to invest, your risk tolerance, the expenses you are willing to tolerate, and the load(s) you are willing to accept.

Are ETFs a Better Choice?

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You may have heard about exchange-traded funds (ETFs), or read about them online, especially comparing them to traditional mutual funds. ETFs do have a number of benefits; however, as with all investments, there are some drawbacks you need to know about before you make the switch.

International limitations, short-term investment focus, and tax implications are some considerations for an investor weighing mutual funds against ETFs.