How Mutual Funds Work

Mutual funds are baskets filled with different types of investments (usually stocks) that allow people to invest while mitigating the risk of choosing individual securities.

Instead of requiring investors to perform the massive task of picking individual stocks themselves, mutual funds allow average investors to simply choose types of funds that would suit them.

And they’re typically one of those personal finance topics people pretend they know about — but don’t actually have any idea what they are.

Mutual funds fall into three categories:

Equity funds are made up of investments of only common stock. These can be riskier (and earn more money) than other types.
Fixed-income funds are made up of government and corporate securities that provide a fixed return and are usually low risk.
Balanced funds combine both stocks and bonds in the investment pool and offer a moderate to low risk. While low risk may sound good, it is also accompanied by lower rates of return-meaning you risk less, but your investment won’t earn as much. You have to decide how much risk you’re willing to take on before you invest your money.

How Do Mutual Funds Work?

When you buy shares of a mutual fund, you’re purchasing a right to a portion of the returns earned by the fund’s portfolio of stocks, bonds and other assets. Mutual means that you split the profits (and the losses) with the other investors in the fund, says Brandon Renfro, a Certified Financial Planner and assistant professor of finance at East Texas Baptist University.

A mutual fund earns dividends and interest from the various investments held in its portfolio. Fund managers can choose to reinvest the profits or distribute them to their investors, depending on their strategy and overall market conditions. When the managers generate capital gains (or losses) by selling assets, they’re also passed on to investors.

Mutual also means that the performance of a mutual fund depends not only on the fund’s manager, but also on the behavior of the investors. When holders sell their mutual fund shares, the fund manager may need to liquidate holdings from the portfolio. The sale of those assets could be ill-timed, resulting in losses for the fund—which may be passed on to the remaining investors.

Mutual Funds are not only for stock market investing

The biggest misconception about investing in Mutual Funds is – investors usually assume that Mutual Funds only invest in the stock markets. But, this is not exactly true. If you are a conservative investor, and you do not prefer to take too much risk, then through Debt Mutual Funds, you can also invest in debt instruments, where the risk factors are much less.

Hence you can choose Mutual Funds, as per your risk appetite, investment horizon, or your investment objectives. And there are tons of Mutual Funds to choose from, and you can pick the one that fits your criteria perfectly.

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