How mutual funds work
Mutual funds are pooled investment vehicles made up of different assets like stocks, bonds, and/or other investments. You, the investor, purchase a share of the fund, representing your slice of ownership. A fund that is well diversified and doesn't rely on a single stock or bond may lower your investment risk - or risk of losing money.
Here's how they work:
You create an investment account. You may already have one through a retirement account (401(k), IRA, etc.), if not—you can easily set one up online or with a financial professional.
This account is where mutual fund(s) can be purchased. There are multiple types of mutual funds with different levels of risk and return potential depending on the asset classes they incorporate and the manager's investment approach. The right type for you may depend on your tolerance for risk and personal investment goals.
Once you've decided to invest in mutual funds, your money is combined with money from other investors - a fund manager uses this pooled money to invest in stock funds, bond funds, money market funds and more.
The fund manager is in charge of choosing the specific holdings in the fund and managing them over time. This can help take a lot of pressure of choosing how to invest your money off your shoulders.
These managed funds are known as active funds, but you can also invest in passive funds. Passive funds seek to mimic an index like the S&P 500.1
You can make money through distributions and capital gains.
Distributions are dividends distributed to fund owners and are only relevant if you’re invested in a mutual fund containing an asset that pays dividends (i.e. stocks).
You earn capital gains by selling your stake in a mutual fund for more than you initially paid for it. You can also receive capital gains distributions. If the price of a security in a fund increases and that fund sells the security with the increased price, the fund has a capital gain. At the end of the year, the fund will distribute these capital gains, minus any capital losses, to investors like you.
Many mutual funds have fees and expenses.
Depending on the type of account, your mutual fund may be subject to certain tax rules and fees. Interest, dividends, and capital gains are all treated differently for tax purposes, and that could affect your return.
Every mutual fund has a NAV (Net Asset Value) calculated by the fund manager at the end of each trading day. They do this by deducting the fund’s liabilities – things like the salaries to pay the fund managers, distribution and marketing expenses, and operating expenses – from the market value of all its shares, then divide by the number of issued shares. This value is what you buy and sell shares at.
- New to investing? Here’s 3 steps to get started.
- Choosing what you invest your money in often depends on your tolerance for risk. Not sure how much risk you’re comfortable taking? Take our quick risk assessment quiz.
- Need some help making sense of the investment options that will help you achieve your retirement goals? We’re here for you. Find a financial professional today.
1 The S&P 500 index is a market value weighted index of 500 leading companies in leading industries in the U.S. economy. You cannot invest directly in an index.
Past performance is not guarantee of future results. Investing involves market risk, including the possible loss of principal. Diversification does not assure a profit or protect against a loss.
The subject matter in this communication is educational only and is not intended to be taken as a recommendation. The information is provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
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