Introduction to Mutual Funds

  1. Mutual funds are investment companies that pool money from many different investors and invest it according to a specific strategy outlined in the mutual fund prospectus. Investors buy shares in each mutual fund and become shareholders. Mutual funds provide investors with diversification and professional management.
  2. A mutual fund makes money for its shareholders by earning dividends and interest on its investments and by selling investments at a profit. Mutual funds vary in their investment strategies: some only invest in bonds, some only in stocks, and still others in both stocks and bonds. Funds may also invest in foreign stocks, bonds and currencies, precious metals, commodities, options, and futures. The scope of investments is specified in the prospectus, the fund website, and by independent analytical companies like Morningstar.
  3. Mutual funds vary in their schedules for paying out income distributions from interest and dividends and capital gain distributions. Funds allow shareholders to reinvest all or part of their distributions to buy more shares of the fund. Shareholders may invest in mutual funds inside retirement accounts like a 401(k) and an IRA and in non-retirement accounts like a brokerage or a living trust. In non-retirement accounts, shareholders pay taxes on distributions whether the money is reinvested or paid out in cash. In retirement accounts, taxes are deferred until the account holder begins to draw income.
  4. Mutual funds vary in their degree of diversification. Sector funds are the least diversified because they invest in just one industry such as technology or healthcare. Having a financial plan helps investors make appropriate choices according to their goals, obligations, time horizons, and their appetite for risk.
  5. Index funds invest in all or most of the stocks or bonds in a particular index. The most popular index is the Standard & Poors 500 (S&P 500) Index which is made up of 500 of the leading U.S. corporations traded on various stock exchanges. Index funds are considered to be passive investments because they mirror a particular index and only make changes in response to changes in the underlying index. Actively managed mutual funds are not tied to an index, and the managers make strategic buy and sell choices based on the objectives of the fund and their outlook for the market and economy.
  6. Shares in mutual funds can be bought and sold everyday the stock markets are open. Share prices are determined every day at the market close by adding up the value of each position in the fund and dividing the total portfolio by the number of shares owned by investors.
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