Understanding Mutual Funds and How They Work

Investing in the market can be complex due to the numerous products in the market. Of all the mentioned investment schemes, mutual funds are one of the most active investment schemes that are preferred by new as well as experienced investors. They present a means of expanding the portfolio and increase the chances of building up wealth in the long run. This article aims at outlining what mutual funds are, how they operate, and why you should consider putting your money in them.

 

Understanding Mutual Funds and How They Work

What Are Mutual Funds?

A mutual fund on the other hand is a collective investment where the pool of money collected from various investors is used to purchase the securities that are included in the fund portfolio. They are invested by professional portfolio managers who intent to reach certain targets of investment including growth, income or conservative capital.  

Types of Mutual Funds

 1.Equity Funds: The following are the characteristics of these funds: These funds mainly invest in stocks. They have capital appreciation as their main objective and they are always associated with high risks but with high returns.

 2.Bond Funds: These are also known as fixed income funds because they are mostly made up of bonds and other debt related securities. They are less volatile than equity funds and the primary objective of these funds is to give regular income.

 3.Balanced Funds: These funds divide the invested amount into stocks and bonds to manage the risk reward ratio. They are meant to offer capital appreciation as well as the regular income.

 4.Money Market Funds: These invest in short term, low risk securities such as T bills. They give a lower rate of return but are deemed to be very secure.

 5.Index Funds: These funds mimic the performance of a certain market index, for instance, Standard & Poor’s 500. They try to mimic the returns of the index and usually have lower expense ratios.

 6.Sector Funds: These are tactics that are fine tuned to certain areas of the economy for instance the technological sector, the health sector or the energy sector. They provide specific opportunities but with higher risks because they are concentrated.

How Mutual Funds Work

Pooling of Funds

 Mutual funds are investment products in which you pool your money with other investors. Thus, the pooled money is invested in a pool of securities with an aim of diversifying the investment portfolio. An investor has an account in the mutual fund and holds certain shares that are proportional to the total funds of the mutual fund.  

Professional Management

 The management of mutual funds is done by fund managers who have the responsibility of buying and selling securities depending on the objective of the particular fund. These managers research, strategize and buy stocks they think will be profitable in the near future.

Diversification

 The first key strength of mutual funds is based on diversification. In this way, mutual funds help to minimize the risk of any one security by investing in many different ones. This is useful in moderating the returns and to avoid big losses.

Net Asset Value (NAV)

 NAV stands for Net Asset Value of a mutual fund share which gives the value of a single unit of the mutual fund. NAV is arrived at by dividing the total amount of the fund’s assets by the number of shares floating in the market. NAV is usually calculated at the close of each trading business day.

Fees and Expenses

 Mutual funds impose charges on the basis of management and administration costs. These can include:

   Expense Ratio: This is the charge made on an annual basis and presented as a percentage of the average fund size. It comprises management charges, overheads and other general expenses.

   Load Fees: Others have a sales charge called a load if you buy or sell shares in the fund. Front end loads are charged at the time of purchase while back-end loads are charged at the time of sale of the shares.

   No Load Funds: These funds do not have any sales loads and the expense ratios could also be relatively lower.

 

 Benefits of Investing in Mutual Funds

Diversification

 Mutual funds give you immediate diversification, which means that your investment is spread out over a number of assets and therefore, the risk is lessened. Thus, mutual funds make investments in a number of securities and prevent the risk of loss of any single security.

Professional Management

 Mutual funds also provide you with professional portfolio management which you would not otherwise have. Fund managers know the strategies, the methods and the tools that help them to make the right decisions on your behalf as an investor who lacks the time or the expertise to make such decisions.

Liquidity

 Mutual funds are very liquid securities that are easy to buy and sell due to their nature of being managed by a fund manager. It is also very flexible in the sense that mutual fund shares can be purchased and sold on any business day and the investor can easily get at his or her money whenever he or she needs it. This comes in handy especially when the investor may be in need of the cash within the shortest time possible.  

Affordability

 It is also easier to start with mutual funds than placing a large amount of money in the market. This makes them easier to approach for investment by virtually any investor, even the one with small capital. Some of the funds also provide the features of Systematic Investment Plans (SIPs) where you can invest a certain amount periodically.

Variety

 Mutual funds are numerous, in the range of thousands, and they all have different goals and approaches to investments. Here you can select the funds that fit your needs notably through your investment objectives, your tolerance to risk, as well as the time period within which you are willing to invest in.

 

 Considerations Before Investing in Mutual Funds

Risk

 As for mutual funds, they provide diversification which is a great advantage; however, they also come with certain risks. The market price of a mutual fund share will rise or fall depending on the performance of the underlining securities. It is crucial to know the particular dangers of the fund type you are looking at.  

Fees and Expenses

 It is also important to note that there are charges and costs that are involved in mutual funds which will in one way or the other affect the returns. Check the expense ratio and the load fees of the various mutual funds so that you are getting your money’s worth.

Performance

 The only problem with the past performance is that it is not an indication of the future performance, although it reveals the quality of the management of the fund. Examine the historical results of a mutual fund and its standard and rival indexes.

Investment Objectives

 The investment objectives of the mutual fund should be similar to your own objectives. For instance, if your target is to have long term returns then equities fund may be ideal. For steady income, go for a bond fund.

 Conclusion

 

 Mutual funds are an attractive way of investing in a number of securities, receiving professional management of the funds, and attaining your financial objectives. Thus, one can comprehend the concept of mutual funds and decide whether to invest in them or not to achieve their desired goals. If you are a new investor or already have an existing investment plan, then mutual funds are a great way to diversify your investment.

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