Mutual funds: A beginner's basics
In basic terms, a mutual fund is a type of investment that pools money from many different investors in order to purchase other investments, such as stocks, bonds, etc. They are normally managed by a portfolio manager whose goal is to generate better financial returns than the market (e.g. the S&P 500, the Dow Jones Industrial Average or DOW, the NASDAQ, etc.). Think of mutual funds as a basket holding many different stocks, cash, bonds or other securities. The goal is to create a more balanced or less risky portfolio. A mutual fund is characterized by a ticker symbol to distinguish it from other mutual funds. For example, FTQGX (Fidelity Focused Stock Fund), FNCMX (Fidelity NASDAQ Compositive Index Fund) are mutual funds.
Why investors buy mutual funds
Investors buy mutual funds for many different reasons. They invest in mutual funds in order to create wealth, achieve financial stability and independence, plan for retirement, vacation, or education. Last but not least, by investing in mutual funds, investors leave the heavy lifting to professional fund managers who research, sell or buy stocks, bonds and other securities for the mutual fund.
How to purchase mutual funds
You can buy mutual funds from a broker for the mutual fund (e.g. Fidelity, E-trade, TD Ameritrade, etc.) or the fund itself. Investors buy mutual funds at the fund's net asset value (NAV). The NAV is nothing more than the price of one share of the fund. Here are the steps you need to take to buy mutual funds: 1) open a brokerage account; 2) fund your account; 3) decide how many shares of the mutual fund you want to buy; 4) choose your order type; 5) complete the order, sit back and celebrate. Although mutual funds are less risky investments compared to stocks, you should always read the fund's prospectus, a document that outlines the fund's investment strategy, fees, risks, among other things. Here's a nice little guide on how to evaluate and select mutual funds for your portfolio.
Benefits and risks of mutual funds
As an investor, owning mutual funds comes with risks and benefits. If the mutual fund's price or net asset value (NAV) goes down, you will lose money and vice versa. There is no certainty that companies whose stocks the mutual fund holds will prosper or do well. To a large extent, a mutual fund's NAV is dependent upon the basket of securities (stocks, bonds, cash, etc) it holds. Many factors affect a mutual fund's share price (NAV), including but not limited to quarterly earning reports of individual companies, regulatory, political, economic and other events.
How you make money from mutual funds
First, you make money when the mutual fund's price goes up or through capital gains. You also make money by earning dividends. Dividends are usually paid to shareholders quarterly. Not all companies pay dividends. Mutual funds are meant to be kept for the long-term. Here's a nice overview of how investors earn money from mutual funds. Check out a nice comparison between stocks, ETFs and index funds.