Mutual Fund – A Beginner’s Guide to Mutual Fund

EducationNovember 25, 2021

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If you’re busy and suffer no delusions about your expertise, you’ll love the best stock mutual funds. Investing in stocks through mutual funds can be as simple as dialing a toll-free phone number or logging on to a fund company’s website, completing some application forms, and zapping them some money.

Despite their popularity, mutual funds can seem complicated or intimidating to many people, especially newbies. In this article, we are going to try to simplify it for you at its very basic level.

1. What is Mutual Fund?

A mutual fund is a type of financial instrument that takes the money invested by people and pool it in a single investment portfolio in securities, such as stocks and bonds. Each mutual fund investor owns a portion of the fund. If the mutual fund performs well (or badly), investors will be therefore distributed proportionally in the gains (or losses) of the fund. The portfolio is managed by professional skilled managers.

Mutual Fund - A Beginner's Guide to Mutual Fund

Mutual funds are a popular choice for individual investors as it offers an opportunity to invest in a diversified, professionally managed basket of securities (stocks, bonds, and others) at a relatively low cost.

2. How do investors earn money from mutual funds?

Investors typically earn money from a mutual fund in three ways:

  • Dividend Payments: Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. The fund then pays the shareholders nearly all the income, less expenses. Or investors also have right to reinvest the earnings and get more shares.
  • Capital Gains Distributions: The price of the securities in a fund may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes these capital gains, minus any capital losses, to investors.
  • Increased NAV: If the market value of a fund’s portfolio increases, after deducting expenses, then the value of the fund and its shares increases. The higher NAV reflects the higher value of your investment. You can then sell your mutual fund shares for a profit in the market.

3. What are Pros & Cons of Mutual Funds?

Mutual funds generally offer the advantages below:

  • Professional Management: Many of us dread the thought of managing our own investments. With mutual funds, you no longer do the market research by yourself, the fund managers help you to analyse, select the securities to invest, and monitor the performance instead.
  • Diversification: Buying individual stocks on your own is relatively costly unless you buy reasonable chunks (100 shares or so) of each stock. But in order to buy 100 shares each in a dozen companies’ stocks to ensure diversification, you need about $60,000 if the stocks that you buy average $50 per share. With mutual funds, you can invest in a variety of companies and industries. This helps to reduce your risk if one company drops.
  • Affordability: Most mutual funds set a relatively low amount for initial investment and subsequent purchases.
  • Liquidity: Mutual fund investors can easily redeem their shares at any time (plus any redemption fees).

As with all investments, mutual funds have some following drawbacks:

  • The issue of control is a problem for some investors. If you like being in control, sending your investment dollars to a seemingly black-box process where others decide when and in what to invest your money may unnerve you. However, you need to be more concerned about the potential blunders that you may make investing in individual stocks of your own choosing or, even worse, those stocks pitched to you by a broker.
  • Taxes are another concern when you invest in mutual funds. Because the fund manager decides when to sell specific stock holdings, some funds may produce relatively high levels of taxable distributions. So, simply select tax-friendly funds if taxes concern you.

4. What are types of Mutual Funds?

Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.

Mutual funds can be broadly classified into 5 groups:

  • Stock funds: As the name suggests, this sort of fund invests predominantly in stocks. Within this group are various subcategories. Some funds invest in income stocks that pay regular dividend. Some focus on growth stocks that have a strong potential for financial gains while some specialize in a particular industry segment.
  • Bond funds: These invest in Fixed Income Securities, like government bonds, corporate bonds, or other debt instruments. When the fund portfolio generates interest income, which it then passes on to the shareholders. These funds are relatively safer investments compared to stock funds.
  • Index funds: These invest in major market index such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires less research from analysts, so there are fewer expenses to eat up returns.
  • Hybrid funds: These invest in a mix of stocks, bonds, and other investments, thus offering the best for Growth Potential and Fixed Income. The objective is to reduce the risk of exposure across asset classes.
  • Money Market funds: they invest only in safe, short-term investments issued mostly by U.S. corporations, and federal, state and local governments.

These types of mutual fund schemes exist to cater to different needs of different people. Depending on your objectives and investment strategies, you can select a suitable fund for yourself.

In conclusion, mutual funds are one of the most viable investment options among investors. Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.

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