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How do Mutual Funds Work?

How do Mutual Funds Work? PhotoLooking for a way to get more out of your money in place of waiting for it to accrue interest in a regular savings account? Then consider investing your money on mutual funds.

What is a mutual fund?

mutual fund is a type of professionally managed collective investment wherein money is gathered from a pool of individual investors to purchase shares and other securities. Money invested can either grow or depreciate depending on the type of investment you choose and the performance of the market.

Types of mutual funds

There are three main categories of mutual funds namely money market funds, bond funds, and stock funds.

  • Money market funds – They have relatively lower risks compared to the other types of mutual funds hence its popularity among individual investors. It has the advantage of having a very short maturity time with high credit quality.
  • Bond funds – Also called fixed income funds. They have higher risks compared to money market funds in return for more promising yields. Usually the money invested is used to pay corporate and government debts. The investor is repaid by providing income through dividend payments.
  • Stock or equity funds – The most volatile and risky of the three types. Their value could rise or fall sharply over a short period of time depending on the stock market performance. Though based on records, stock funds perform better in the long run compared to the other types of investments.

Difference from other accounts

Other types of accounts let you handle your money the way you want to. With mutual funds, investments are managed by a professional investment manager whose job is to place the money where the most effective growth could be achieved.

Mutual funds are not guaranteed or insured by the FDIC or any other government agency, even if you buy it from a bank covered by the FDIC. It’s included in the risks involved in investing in mutual funds.

Advantages and disadvantages

The obvious benefit is the promise of getting relatively higher yields. It’s also affordable with banks offering various packages to those who want to get started. Funds are also professionally managed by someone who specializes in investing so you won’t need to worry about where to put your money to get the highest yield.

Another advantage is that mutual funds are liquid. You can readily redeem your share anytime you want.

However there are also disadvantages involved investing in mutual funds. Unlike in a regular savings account, money invested in mutual funds isn’t covered by the FDIC. That means there is no guarantee you’ll recover the same amount you invested initially.

Interest rates are also uncertain and uncontrollable. The price at which you purchase or redeem shares will typically depend on the fund’s net asset value or NAV. Calculations in exchange rates might not be in real-time and could possibly happen only hours after you’ve made a transaction.

Rate of return

The NAV or Net Asset Value is the value of your share in a fund. It’s the price you pay to buy a certain amount of shares. This will also be the value that would determine how much you’ve gained or lose in the investment.

Rates also vary depending on the market performance and the money management type you chose. Market shares are fluctuating and quite tricky to predict affecting the interest you could get.

Taxes

Gains from dividends are also taxable the year you receive or reinvest them. It’s considered an extra source of income so you’ll need to file it under that condition. Taxes also apply on any capital gains you receive when you sell your shares.

Investing in treasury and municipal bonds has the benefit of being tax-exempted after reaching its maturity date.

Investing

You can start investing by talking about it with your current bank. Banks offer varying amounts in which you could invest with some offering as low as $1,000 and other a minimum of $20,000. There are also options if you would like to put it in low-risk with relatively lower yields or in one that’s more risky but has the possibility of higher gains.

It’s best to shop around and look for one that you can afford and would best suit your character.