Investing in mutual funds is a great way to make money and build wealth over time. Compared to stocks, mutual fund investments offer investors a more diversified portfolio and less risk. How do you invest in mutual funds if you don't understand how they make you money? Here's how.
You make money from mutual funds in two major ways. First, you make money when the mutual fund's net asset value (NAV), also known as its share price, minus expenses, goes up. You also make money by earning dividends. Dividends are a portion of the mutual's earnings that it pays to shareholders. Not all mutual funds pay dividends. For the sake of simplicity, here's a simple overview of how investors make money from mutual fund investments.
Being the curious investor that you have become, you came to the realization that the $300 tucked away in your mattress for the last 5 years has collected $0 in interest and even lost value through inflation. Instead of picking individual stocks, you evaluated and picked a good mutual fund: mutual fund WXYZ at $8.50 a share. Mutual fund WXZY holds a basket of 25 individual stocks, some of which pay dividends. You acquire 35.294 shares of this mutual fund (300/8.50 = 35.294). The good thing with mutual funds is that you are allowed to purchase fractions of shares! You do not have this option with stocks. Since mutual funds are meant to be kept for the long haul, you decide to cash out your earnings and walk away after 10 years. 10 years later, mutual fund WXYZ has reached a NAV, minus expenses, of $16.75. The fund has decided to share its profits with shareholders (lucky you!) with a dividend payment of $0.30 a share. You sell all your shares (35.294) and walk away with some hard cold cash. How much did you make?
1. You make money from selling shares.
By selling all your shares of mutual fund WXYZ at the new share price of $16.75, you earn: 35.294x16.75 = ~ $591! This amount has put your mattress to shame!
2. You make money through dividends.
Remember that the timing of mutual fund dividend payments vary widely. In the interest of simplicity, we're going to assume this is the first time this mutual fund is paying its shareholders that $0.30 dividend. Your dividend earnings would be: 35.294 shares x 0.30 = ~$10.60. In 10 years, you earn more in dividends than your mattress pays you in interest. Overall, having invested your $300 in mutual fund WXYZ, you proudly walk away with $601.60! Congratulations on your first legal stock market heist!
The bottom line
There are two major ways investors make money from mutual funds: selling shares and earning dividends. Of course the example illustrated above did not take into account broker, trading and other mutual fund fees. Moreover, we assumed that no additional shares were purchased. To better illustrate how investors make money from mutual funds, check out this real 3-month investing experiment. In the meantime, here's a good way to evaluate and select mutual funds.
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