Mutual funds now make up a vast proportion of the retirement assets American have invested through their 401(k) plan at work, their Roth IRAs, their Traditional IRAs, their 403(b)s, their SEP-IRAs, their SIMPLE IRAs, or any number of other types of retirement account. Unfortunately, many new investors can’t actually tell you what a mutual fund is, how a mutual fund works, or how someone actually makes money from owning a mutual fund.
In this brief introduction, I hope to change that by answering some of those questions.
Apart from Sheer Luck, You Can’t Start Making Money Investing in Mutual Funds Until You Understand What They Are
Before you can understand how investors make money investing in mutual funds, you have to understand what a mutual fund is. Start by reading The New Investor’s Guide to Mutual Fund Investing, which is an extensive resource I put together to help you learn all about mutual funds. In particular, you may want to read How a Mutual Fund Works. If you’re short on time, let me reiterate a condensed version.
Simply stated, a mutual fund is a term used to describe a type of company that doesn’t do anything itself, but rather it owns investments. The company, which is the mutual fund, hires a portfolio manager and pays him or her a management fee, which often falls between 0.50% and 2.00% of assets. This portfolio manager invests the money raised by the fund according to the strategy laid out in a document called the mutual fund prospectus.
Some mutual funds specialize in investing in stocks, some in bonds, some in real estate, some in gold. The list is practically goes on and on with mutual funds organized for nearly every type of investing strategy or niche you can imagine. As I mentioned in Making Money Investing in Dividend Stocks, there are even funds designed for people who only want to own dividend stocks in the S&P 500 that have increased the dividend every year for the past 25 years!
It is safe to say that there is a mutual fund for almost any objective you may wish to achieve.
The Ways An Investor Might Actually Make Money from Owning Mutual Funds
How you start making money when you invest in a mutual fund depends upon the type of fund you own. If you own a stock fund, you already learned in Making Money from Investing in Stocks that the biggest sources of potential profit are an increase in the stock price (capital gains) or cash dividends paid to you for your pro-rata share of the company’s distributed profits. If the fund instead focused on investing in bonds, you are making money through interest income. If the fund specializes in investing in real estate, you might be making money from rents, property appreciation and profits from business operations, such as vending machines in an office building.
The Three Keys to Making Money Through Mutual Fund Investing
There are three major keys to making money through mutual fund investing. These are:
Only Investing in Mutual Funds You Understand – If you can’t explain, quickly, succinctly, and with specificity, exactly how a mutual fund invests, what the risks of the mutual fund’s investment strategy are, and why you own a particular mutual fund, you probably shouldn’t have it in your portfolio. It’s much easier to measure, contain, and appreciate risk when you keep things simple.
Think In Periods of 5 Years or More – It’s much easier to let your wealth compound if you can ride out the sometimes sickening market volatility that is part and parcel of investing in stocks or bonds. If you own, say, an equity mutual funds, be prepared for it to decline by 50% in any given year. These things happen. Presuming you’ve drawn up a well-researched, sound plan based on common sense, basic mathematics, and prudent risk management strategies, allowing yourself to become emotional and sell your productive assets at the worst possible time is not likely to cause you to build a lot of wealth.
Pay Reasonable Expenses – Costs matter when it comes to mutual funds though they are not the only consideration. Tax efficiency matters. Income needs matter. Risk exposure matters. All need to be weighed against each other and other relevant factors. The key point is to make sure you are getting value for what you pay.