What You Need to Know before Investing in Mutual Funds

What You Need to Know before Investing in Mutual Funds

Even with a limited income, it is often possible to save money, and regardless of your income, once you start saving money, it is a good idea to invest it to achieve your financial goals, whether those be purchasing a home, retiring, and/or something else. An investment vehicle that pools money from multiple investors to purchase stocks, bonds, and other assets, mutual funds generally enable a level of diversification that would be challenging for average investors to achieve on their own. Hence, you don’t necessarily require a lot of money to develop a diversified portfolio, but can achieve diversification simply by purchasing mutual fund shares.

How Mutual Funds Can Increase Your Wealth

Mutual funds can make you money in various ways, the most obvious of which is via net asset value. The price per mutual fund share is known as net asset value, which goes up as the value of the fund increases. This works very similarly to stocks. While you do not see an immediate gain in funds, the value of the investment increases, and you have the potential to make money should you desire to sell the shares. Beyond that, you may receive dividend payments, which is sort of like interest generated from securities in the mutual fund portfolio. You can receive these payments directly or have them reinvested in the fund. Mutual funds will also distribute capital gains from selling securities to investors on an annual basis.

While mutual funds generally earn you money, all investments carry risk, so you could potentially lose money if the shares decrease in value. However, because mutual funds are inherently diverse, the risk of losing money is generally much less than investing in individual stocks or other discrete assets. Also, it is important to remember that the market is inherently volatile, so if the investment decreases in value, it will likely go back up over time. For that reason, mutual funds are not necessarily a good investment if you need the money in five years or less.

Types of Mutual Funds

Several types of mutual funds exist, so it is important to understand what you are investing in when you buy a share. Mutual funds can be managed passively or actively. Passively managed mutual funds track a market index, such as the S&P 500. Because such funds are not actively managed, they have lower management fees. However, these funds’ potential for growth is generally less than it would be with actively managed funds.

Beyond these designations, mutual funds can be divided into many other categories, depending on the assets of which they are comprised. While some mutual funds focus on a single asset class, others have a much wider variety.

Stock funds generally have the greatest risk and the largest potential for high returns because they invest primarily in a rather volatile asset. Fluctuations in the stock market will have a dramatic effect on the performance of these funds. Even within this class, there are funds that focus on a specific sector or type of stocks, such as growth funds.

An option with less risk is a bond fund. Many different types of bonds exist, and some funds may focus on particular ones while others may have greater breadth.

The term “balanced fund” refers to a mutual fund with a mix of stocks, bonds, and other securities. Sometimes, these assets are actually a fund of funds, meaning they invest in other mutual funds.

Another common option is a money market fund, which invests in high-quality, short-term investments. Money market funds have low risk but also low returns.

Things to Consider When Investing in Mutual Funds

After deciding to invest in mutual funds, it is time to consider your investment options. In the course of doing so, be sure to take associated fees into account; even passively managed funds charge an annual management fee, which is typically a percentage of cash invested. Also known as the expense ratio, such a fee has the potential to cut into your earnings rather substantially, so pay close attention to those. Moreover, look at the mutual fund prospectus to identify any other fees. Since fees for passively managed funds should be relatively low, make sure to ask questions if you see that they are not.

Also, consider whether the fund has loads, which is sort of like a commission. With a load fund, the mutual fund will charge a commission for the broker or salesperson who sells the fund. Generally, this cost gets passed on to the investor, so it can influence how many shares you are able to purchase. No-load funds do not have transaction fees for the purchase or sale of shares. Most investors opt for no-load funds because they are easier to purchase and sell. Plus, you can maximize your investment total when you purchase shares of a no-load fund.