How do you make money investing in mutual funds? Basically, there are two ways to make money and two ways to lose money investing in mutual funds. Let’s go to the basics.
There are thousands of funds to choose from and the vast majority of them will fall into one of four categories based on where they invest the money (your money). They are called: equity funds (stocks), bonds, money market and balanced funds. In all of the above you open an account, invest money and this buys you shares. You earn money by investing based on the number of shares you own. The same happens if you lose money investing.
Let’s start with the most popular and riskiest category called EQUITY FUNDS, which invest money in stocks, also called “stocks.” Why invest money here? The primary objective is growth, with dividend income as a secondary objective. You make money by investing here when share prices and dividends rise. You lose money when the stock price goes down. Dividends come from the shares in the fund’s portfolio and are passed on to you. They (like all dividends) are yours to keep. The main attraction of equity funds: the potential for high returns.
The BOND FUNDS have one primary goal: increased income in the form of dividends. They are also called INCOME FUNDS and are generally safer than the stock variety. You invest money here for higher dividends than you can get elsewhere. Dividends come from interest earned on the fund’s bond portfolio. You can also make money by investing when the stock price rises; and lose money when the stock price falls. Typically, there is considerably less price fluctuation than what you will find in the stock or equity category.
BALANCED FUNDS are a happy medium between the previous two, because they invest money in both stocks and bonds. So you make money from both rising stock prices and dividends, and lose money by investing when stock prices fall. Here you have a moderate risk.
MONEY MARKET FUNDS are the safe alternative and money is earned by investing in them in only one way: dividends. They invest money and earn interest on high-quality short-term notes (on the money market). This interest is passed to you in the form of dividends. The share price is fixed at $1 and does not fluctuate. Investors very rarely lose money by investing here.
Most people invest money in mutual funds as a long-term investment. So, in most cases, they simply allow the fund company to reinvest all dividends (and other distributions) to buy more shares. Distributions (such as capital gains from the sale of stock) are a bit technical. Don’t worry, if you have them, you’ll get your cut. And you’ll also receive periodic statements showing activity on your account.
At the beginning we said that there are basically two ways to make money and two ways to lose money investing in mutual funds. What is the second way to lose money? Let me give you an example, and as a former financial planner I have seen this happen over and over again. Joe Blow decided to invest money in mutual funds through a “financial planner” (not me). You invested $20,000 in a stock fund and about a year later you looked at your last statement and it showed a total value of $19,000.
The stock market in that year showed a modest gain. How did you lose money investing? Answer: $1,000 came off the top to pay sales charges called “loads.” About $300 went to spending annual funds and another $300 to additional fees. Joe claims that he knew nothing about these charges and fees.
There is no need to pay a lot of money when you invest money in mutual funds. If Joe had opted for NO LOAD funds, he could have invested for a total cost of about $200 a year, for expenses. You can earn money by investing in mutual funds as a long-term investment. Just don’t work against yourself by losing money due to high charges and fees.