Mutual Fund Investing 101: How You Make Money
How do you make money investing in mutual funds? There are basically two ways to make money and two ways to lose money investing in mutual funds. Let’s get down to the basics.
There are thousands of funds to choose from and the vast majority will fall into one of four categories based on where they invest money (your money). They are called: stocks (shares), bonds, money market and balanced funds. In all of the above, you open an account, invest money, and that buys you shares. You make money investing based on the number of shares you own. The same is true if you lose money investing.
Let’s start with the most popular and riskiest category called EQUITY FUNDS, which invest money in stocks, which are also called “shares”. Why invest money here? The primary objective is growth, with dividend income as a secondary objective. You make money by investing here when the share price goes up and from dividends. You lose money when the stock price falls. Dividends come from the shares in the fund’s portfolio and are passed on to you. They (like all dividends) are yours to keep. The main appeal of equity funds: the potential for high returns.
BOND FUNDS have one main goal: higher income in the form of dividends. These are also called INCOME FUNDS and are generally safer than the equity variety. You invest money here to earn higher dividends than you can get elsewhere. Dividends come from interest earned on the fund’s bond portfolio. You can also make money by investing when the stock price goes up; and lose money when the stock price falls. There is usually significantly less price fluctuation than you will find in the stocks or shares category.
BALANCED FUNDS are a happy medium between the two above because they invest money in both stocks and bonds. Therefore, you make money from both rising stock prices and dividends, and lose money investing when stock prices fall. You have moderate risk here.
MONEY MARKET FUNDS are the safe alternative and you make money investing in them in only one way: dividends. They invest money and earn interest in high-quality, short-term debt instruments (in the money market). They pass this interest on to you in the form of dividends. The stock price is fixed at $1 and does not fluctuate. Very rarely do investors lose money investing here.
Most people invest money in mutual funds as a long-term investment. So in most cases, they simply allow the fund company to reinvest any dividends (and other distributions) to buy more shares. Distributions (such as capital gains from the sale of stock) are a bit technical. Don’t worry—if you make them come, you’ll get your share. You will also receive periodic statements showing your account activity.
We said at the beginning that there are basically two ways to make money and two ways to lose money investing in mutual funds. What is the second way to lose money? Let me give you an example and as a former financial planner I have seen this happen time and time again. Joe Blow decided to invest money in mutual funds through a “financial planner” (not me). He put $20,000 into a mutual fund and about a year later he looked at his last statement and it showed a total of $19,000.
The stock market showed moderate growth this year. How did he lose money investing? Answer: $1,000 came out of the top to pay sales fees called “loads.” About $300 went to annual financing costs and another $300 to additional fees. Joe claims he knew nothing about these fees and charges.
You don’t need to pay big bucks when you invest money in mutual funds. If Joe had chosen NO-LOAD funds, he could have invested at a total cost of about $200 per year in expenses. You can make money investing in mutual funds as a long-term investment. Just don’t work against yourself by losing money to high fees and charges.
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