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 basics.
There are thousands of funds to choose from and the vast majority of them will fall into one of four categories based on where they invest money (your money). They are called: equity (stock), bond, money market, and balanced funds. In all of the above you open an account, invest money, and this buys you shares. You make money investing based on the number of shares you own. The same goes if you lose money investing.
Let’s start with the most popular and the riskiest category called EQUITY FUNDS, which invest money in stocks, which are also called “equities”. Why invest money here? The primary objective is growth, with dividend income as a secondary objective. You make money investing here when the share price goes up, and from dividends. You lose money when the share price goes down. The dividends come from the stocks in the fund portfolio and are passed on to you. They (like all dividends) are yours to keep. The primary attraction of equity funds: the potential for high returns.
BOND FUNDS have one primary objective: higher income in the form of dividends. They 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. The dividends come from the interest earned in the fund’s bond portfolio. You can also make money investing when the share price goes up; and lose money when the share price falls. Normally, there is considerably less price fluctuation than you’ll find in the equity or stock category.
BALANCED FUNDS are a happy medium between the two above, because they invest money in both stocks and bonds. Hence you make money from both rising share prices and dividends, and lose money investing when share prices tumble. Here you have moderate risk.
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 IOUs (in the money market). This interest they pass on to you in the form of dividends. Share price is pegged 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 all dividends (and other distributions) to buy more shares. Distributions (like capital gains from the sale of stock) are a bit technical. Don’t worry – if you have them coming, you’ll get your share. And you’ll also receive periodic statements showing the activity in your account.
In the beginning we said that there are basically two ways to make money and two ways to lose money investing in mutual funds. What’s the second way you can lose money? Let me give you an example, and as a former financial planner I’ve 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 stock fund, and about a year later he looked at his latest statement and it showed a total value of $19,000.
The stock market in that year showed a modest gain. How did he lose money investing? Answer: $1000 came off the top to pay for sales charges called “loads”. About $300 went to yearly fund expenses, and another $300 to extra fees. Joe claims that he didn’t know anything about these charges and fees.
It is not necessary to pay big bucks when you invest money in mutual funds. Had Joe gone with NO-LOAD funds, he could have invested for a total cost of about $200 a year, for 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 charges and fees.