Mutual funds are the investment product that many people chose when they make their first investment. A mutual fund is an investment company that collects deposits from many people and invests the money in a variety of securities (e.g., stocks and/or bonds). The company then manages the money on an ongoing basis. The combined stocks, bonds, and other securities within a mutual fund are known as its portfolio. Each investor owns shares, which represent a part of the holdings of the total portfolio.
Examples of investment companies include Vanguard, Fidelity, T. Rowe Price, American Funds, and Franklin Templeton. These and other companies that offer a variety of mutual funds with different investment objectives (e.g., income and growth) are collectively referred to as a “family” of funds.
Before purchasing shares of a mutual fund, read the fund’s prospectus, study the fund’s fee table, consider the fund’s objective in relation to your own investment objectives, and know the fund’s performance history. In addition, take note of the minimum required investment amount.
There are three ways that investors can make money on mutual funds:
• Dividends and Interest- A fund may receive income in the form of dividends and interest on the securities that it owns. Bonds pay interest and some stocks pay dividends. A mutual fund company will pass this income on to its shareholders. You generally will be taxed yearly on this amount unless the fund holds tax-free securities (e.g., municipal bonds).
• Capital Gains/Losses on Securities in a Fund- Prices of the securities in a fund may increase. When a fund then sells a security, it has a capital gain. At the end of the year, most mutual funds will distribute these capital gains, minus any capital losses (i.e., reduced prices of securities) to their investors. These capital gains will be taxed each year when they are received.
• Increased Net Asset Value (NAV) of a Mutual Fund- If a company does not sell, but, rather, holds securities that have increased in value, the value of the shares of the mutual fund will increase when there is a profit. This also is a capital gain. However, investors will not be taxed on this capital gain until the year that they sell their fund shares.
There are three major categories of mutual funds by objective:
• Income- Funds (e.g., bond funds, income funds) that focus on dividends and interest that provide regular income payments to investors.
• Growth- Funds (e.g., growth funds , aggressive growth funds, sector funds) that focus on increasing the value of the principal (i.e., the amount invested) through capital gains and net asset values. Growth funds are usually more risky than income funds but offer a greater potential return.
• Stability- Funds (e.g., money market funds) that focus on protecting the amount invested from losses so the fund’s NAV does not go down. This is the least risky type of fund but may make the least amount of money.
Mutual funds are an excellent first investment for beginning investors. However, since there are thousands of mutual funds, careful examination before purchasing and at least yearly monitoring of the fund’s performance are necessary. Remember that the stock market goes up and down and a long-term perspective is needed.
