Now that we know what mutual funds are…let’s talk about how they actually work, and how you can make money off them!
How Mutual Funds Work
Mutual funds are among the most popular — and often misunderstood — of all the investment options. If you are still in a “learn to trade stocks” mode, a mutual fund can improve your portfolio, particularly if you are a modest investor.
Disregard the over-simplifications espoused by many. Mutual funds are a way to own more diversified and higher priced stocks for a small amount of money. This is accomplished through the pooling of others’ funds to purchase investments for the fund. Pooling smaller amounts of money allow Wall Street to purchase larger blocks of or stocks that are more expensive.
Most mutual funds are called “open-ended” funds because they will continue to take your cash, manage it for you, and issue shares to show your ownership. Each night the mutual funds calculate the value of all of their holdings and divided that value by the number of shares they have issued, and that number is called the Net Asset Value or NAV. So if the Fidelity Bank Fund had a value of $10.00 and your write them a check for $5,000 you would now own 500 shares of this fund. Gains, losses, and earnings are mutually shared with investors in proportion to the size of their investment.
Mutual Funds are not traded on an open market like stocks and the prices of mutual funds are calculated just once a day, at the end of every trading day. The price for a mutual fund is called the Net Asset Value (NAV) because it is a calculation of the entire value of stocks and other assets held by the fund divided by the total number of shares outstanding:
Mutual Fund NAV = Value of stocks and other assets / Shares outstanding
Since Mutual Fund NAV’s are calculated just once a day, mutual funds can’t be traded several times during the day like a stock. In fact, it is generally discouraged to trade several times in and out of mutual funds. Most mutual funds impose penalties and redemption fees upon withdrawal from the mutual fund to discourage active trading.
Making Money off Mutual Funds
There are two main ways to make money off of mutual funds: through capital gains and through distributions.
Capital gains are determined by what you make (or lose) by selling your find. You’ll have a capital gain if you sell your mutual fund for more than you paid for it. You’ll have a capital loss if you sell it for less than you paid.
Distributions depend on the type of fund you purchase. Certain mutual funds will bring you dividends, interest or capital gains. You can request that the distributions be paid in cash, but unless specified they will usually be automatically reinvested.
Other Mutual Funds Basics
Understanding where money has been is the first step in understanding where money is going particularly when it comes to mutual funds. The Law of Diminishing Returns dictates the rate of growth slows the longer it continues. Savvy investors understand this tendency and use it to precipitate a reversal or even change of investment vehicle.
This is particularly useful to provide insight into the future moves of institutional investors who are often under severe pressure to maintain a reliable rate of growth for vast sums.
One of the quick measures to keep a continuous eye on is mutual fund inflows. By measuring the absolute and relative rate of inflows it can provide an early indication of sentiment for both individual funds and the market as a whole.
Choosing mutual funds is an important and often overwhelming experience – we know. We’ve got you covered. Our ”Putting Your Money in the Market” course will teach you everything you need to know about how mutual funds work, so that you can make an informed and educated decision.