How do you make money investing in mutual funds? Basically, there are two ways to make money and two ways to lose money by 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 their money (your money). They are called: variable income 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 is true if you lose money investing.
Let’s start with the most popular and riskiest category called EQUITY FUNDS, which invest money in shares, also called “stocks.” Why invest money here? The primary objective is growth, with dividend income as a secondary objective. You make money investing here when the stock price and dividends go up. 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.
BOND FUNDS have one main objective: 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 to earn higher dividends than you can 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 stock category.
BALANCED FUNDS are a middle ground between the two above, because they invest money in both stocks and bonds. So you make money from both rising stock prices and dividends, and you 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 in high-quality, short-term notes (in the money market). This interest is passed to you in the form of dividends. The stock 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 stock sales) are a bit technical. Don’t worry, if you have them, you’ll get your share. 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 by 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 time and time again. Joe Blow decided to invest money in mutual funds through a “financial planner” (not me). He invested $20,000 in a stock fund and about a year later he looked at his 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 out of the top to pay for sales charges called “loads.” About $300 went toward annual fund spending and another $300 toward additional fees. Joe claims that he did not know anything about these charges and fees.
You don’t have 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. He can earn money by investing in mutual funds as a long-term investment. He just doesn’t work against you by losing money due to high fees and charges.