A mutual fund is an investment company that collects deposits from many people and invests it in a variety of securities. The company then manages the money on an ongoing basis. The combined stocks, bonds, and securities of a mutual fund are known as its portfolio. Each investor owns shares, which represent a part of the holdings of the total portfolio.
Usually, investment companies have a variety of funds to sell. Examples of investment companies include Vanguard, Fidelity, Janus, T. Rowe Price, American Funds, and Dreyfus. These and other companies have many mutual funds with different investment objectives.
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.
There are three ways investors can make money on mutual funds:
1. 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.
2. 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 (reduced price), to the investors. These capital gains will be taxed each year they are received.
3. 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, you will not be taxed on this capital gain until the year that you sell the fund.
There are three major categories of mutual funds by objective: A. Income--Funds that focus on dividends and interest that provide income to investors. B. Growth--Funds that focus on increasing the value of the principal or amount invested through capital gains and net asset values. Growth funds are usually more risky but offer greater potential return. C. Stability--Funds that focus on protecting the amount invested from loss 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.