Investing in Mutual Funds
When you buy shares in a mutual fund, you're adding your money to the assets the fund uses to build and maintain a whole portfolio of investments. The investments that the fund makes depend on the type of fund it is and its investment objective, or the results it wants to achieve.
You're usually required to meet an initial minimum investment in a fund. Once you've done that, you can usually make smaller investments whenever you'd like.
As an investor, you share in the fund's return is proportion to the number of shares you own. Dividend or interest earnings from the fund's investments and profits the fund realizes from selling investments are paid to you as distributions. You can take them as cash or reinvest them to buy more shares in the fund.
A few words of caution: there's no guarantee that any investment, even a mutual fund investment, will be profitable, pay distributions, or meet or maintain its investment objective. You'll see that as a recurring theme - all investments have some degree of risk. In this case, the risk is that you'll lose some or all of the money you've invested.
How do Mutual Funds Work?
There are two primary categories of mutual fund: actively managed and passively managed.
Professional managers run actively managed funds. The managers authorize the purchase and sale of investments for the fund's portfolio and oversee its operations. Skilled managers may assemble a fund that performs better than funds with similar objectives, and sometimes better than the stock or bond markets as a whole. However, mutual fund performance is not guaranteed, and even the best-managed fund can provide disappointing returns in some periods.
Passively managed funds are linked to an underlying market index. The fund owns some or all of the investments covered by the index. Its portfolio changes only when the make-up of the index changes. Its objective is to replicate the performance of the index, whatever that is. One thing to know is that you're not investing in the index directly, so your returns will never exactly match those of a fund that tries to replicate an index.
Some Things to Look For
When you want to invest a new fund or evaluate one you already own, you'll want to consider:
- Performance. Performance is the return on your investment, or the profit or loss you have in relation to the amount you invested. You're interested in how they compare to the returns of comparable funds. Past performance isn't a guarantee of future results, but it can provide some insight on how the fund has done in strong and weak markets. You also want to know if the returns are consistent. That's not the case with a fund whose long-term performance history has one or two very good years and eight or nine mediocre or poor ones.
- Risk. Risk is primarily a measure of the fund's potential for short- or long-term loss. Taking some risk is essential if you're investing for the long term. But you might want to consider your ability to tolerate some losses without selling in a panic if the fund drops in value. One thing to consider is inflation risk, which can undermine the value of very safe investments that pay returns that are lower than the rate of inflation.
- Costs. The transactions costs you may pay to buy and own a fund can seriously affect your return. If you don't pay a sales charge, called a load, all of your principal is invested in the fund. But if you pay a high load, less of the money you invest actually goes to work for you. All funds have some fees, but some funds have higher fees than others.
Open-end and Closed-end Funds
Open-end mutual funds issue as many shares as you and other investors want to buy. A fund will also buy back any of its shares that investors want to sell. Closed-end mutual funds issue a fixed number of shares to raise money all at once. After issue, the shares are traded among investors on an exchange, just as stocks are.
Some consider international investing to be a wise move, both as a way to offset weak performance at home and to take advantage of strong potential returns abroad. But it can be complicated and costly if you do it on your own. That's why many people invest overseas through mutual funds. Funds handle the tax and currency issues for you, making the process easier. They also provide broader diversification that you probably couldn't achieve on your own, and at a more reasonable cost.
Dollar Cost Averaging
Dollar cost averaging means investing a fixed dollar amount every month in the same investment, regardless of what is happening in the financial markets. That way, the price you pay tends to even out over time, since you never pay only the highest or lowest price. But for this strategy to work, you have to invest when the prices are down as well as when they are up.
For example, if the price per share varied over a year from a low of $8.45 a share to a high of $11.50 a share, you would have bought some shares high and some low. In the long run, you may come out better with this approach than by trying to pinpoint the moment the price will hit bottom. Dollar cost averaging doesn't guarantee a profit, though, or prevent you from losing money. It also doesn't mean that you are better off than if you had invested large amounts at the beginning of a market rise.
But what dollar cost averaging does best is it keeps you investing. And adding money to your account on a regular schedule is an important way to build your account value.