Investing in mutual funds

When you put money into a mutual fund, it’s pooled with other investors’ money and used to make investments that the fund manager has identified as having the potential to produce the results the fund wants. Skilled managers can mean a fund 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.

Because a fund makes many investments, you get the advantage of diversification. This means that even if some of the fund’s investments are performing less well than the manager expects, others may be doing better. A typical stock fund, for example, might own shares in more than 100 companies. And you can get added diversification by buying several different funds, with different objectives.

How Do Mutual Funds Work?

Professional managers direct actively managed funds, authorizing the buying and selling of investments for the fund’s portfolio. Investors are credited with profits or losses in proportion to the number of shares they own. Earnings on investments and profits from selling investments are paid out as distributions, and may be taken as cash or reinvested in the fund.

For most funds you’ll have to make an initial investment of $500 to $3,000. Once your account is open, however, you can make additional purchases whenever you like, usually for as little as $100, and sometimes less if you arrange direct deposit from your paycheck or bank account.

What to look for

When you choose a new fund or check on one you own, there are a few things you may want to evaluate:

Performance is how much the fund returns on your investment, whether the returns are consistent, and how they stack up against 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 been operated.

One guideline: Be wary of any fund whose high returns are based on one or two stellar years and eight or nine dull ones.

Risk measures how likely you are to earn or lose money, both in the short term and over time. Taking some risk isn’t bad if you’re investing for the long term, and you can tolerate some setbacks without selling in a panic if the fund drops in value.

You also have to consider inflation risk, which can undermine the value of very safe investments that pay only small returns.

Costs you may pay to buy and maintain the fund can erode your return. If you pay high commissions or fees, less of the money you put into your account actually goes to work to produce investment income. For example, if you pay a 5% up-front commission on each $1,000 you put in, only $950 of it is actually invested.

The advantages of mutual funds

  • Convenience of buying and selling
  • Diversified investments
  • Professional management
  • Automatic reinvestment option
  • Distribution options
  • Telephone redemption and transfer available

Open-end vs. closed-end funds

In an open-end fund, the more you — and other investors — put in, the larger the fund grows as it issues more shares to meet the increasing demand. The fund will also buy back any of its shares that investors want to sell. You can invest either directly with the issuing company or through your stockbroker or financial adviser, depending on the fund.

Closed-end funds are traded on the major exchanges, as stocks are. There is a fixed number of shares available because the fund raises its money all at once. Shares often trade at a discount from their net asset value (NAV), but sometimes cost more than the NAV if they’re hot. Most funds that invest in a single country — such as a Mexico fund — are closed-end funds. You buy these funds through a broker.

Load vs. no-load funds

If you buy a mutual fund through a broker, bank, or other third party, it will probably be a load fund, which means you pay a commission, typically between 2% and 5%. With a front-end load you pay when you make a purchase, and sometimes on your dividend reinvestments as well. With a back-end load you pay when you redeem, or sell, your shares. With level-load funds, you pay a percentage of assets each year.

No-load funds, which you buy directly from the mutual fund company, have no commissions but some funds may charge fees to cover sales and marketing costs.

When should you invest?

Invest almost anytime, but not just before a stock fund makes its annual capital gains and income distributions, usually in December. If you invest then, you’ll probably pay more per share, and owe tax on the distribution. Then the price will drop by the amount of the distribution.

Investing overseas

Many investors use mutual funds to expand their portfolios to include worldwide markets. Most experts agree that international investing is smart, both as a hedge against slow times at home and to take advantage of strong economies abroad. But investing overseas can be complicated, for reasons ranging from currency values to taxation policies to political instability. Funds handle the tax and currency issues for you, making the process easier.

Dollar cost averaging 

Dollar cost averaging means investing a fixed dollar amount every month, no matter what’s happening in the financial markets. That way, the price you pay tends to even out over time, and you never pay only the highest or lowest price — provided that you 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 $10.65 to $8.45 to $11.50, you would have bought some shares high and some low. In the long run you may come out better than by trying to pinpoint the moment the price hits bottom or tops out. Dollar cost averaging doesn’t mean, though, that you can’t lose money, or that you wouldn’t be able to make more if you invested large amounts at the beginning of a market rise.

 

 

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