A mutual fund is a type of investment that pools a group of investors’ resources to access a bundle of stocks, bonds, or other securities.
When you buy a stock, you invest in a company’s equity. In contrast, when you invest in a mutual fund, you buy shares of a business that buys stocks in other companies or securities. Mutual fund holders don’t have voting rights the way they do with stocks.
Professional money managers oversee mutual funds on investors’ behalf. You can buy into a mutual fund through a large traditional investment firm like Charles Schwab or T. Rowe Price, or newer digitally-native firms.
How do mutual funds work?
The price of a mutual fund, which determines what you pay for its shares, is called its net asset value (NAV). To calculate a fund’s NAV, you divide the total value of all the securities in its portfolio by the number of shares owned by shareholders, institutional investors, and company stakeholders, among others. As opposed to stock prices, which fluctuate with the market, the NAV is set at the end of each day of trading.
How investors earn returns from mutual funds
Money invested grows when the value of the fund increases, based on gains in the underlying assets. The securities the fund owns also earn dividends and interest, which the fund passes through and distributes to shareholders. The fund may sell securities when they rise in value, and you and other investors are owed a share of this money.
You’re responsible for paying any taxes on this money, particularly income taxes (for dividend and interest payouts) and capital gains taxes for securities trading.
Active vs. passive mutual funds
With active funds, professional money managers oversee the fund’s portfolio. They buy and sell securities in the fund, whereas a casual investor may lack the time, resources, or expertise to commit to this trading.
Passively managed funds aim to replicate the moves of a market index like the S&P 500 and don’t require an investor’s oversight. One well-known example is the Vanguard 500 Index Fund. Passively managed funds generally have lower fees than actively managed funds.
Types of mutual funds
There are different types of mutual funds for nearly every type of investor and investing approach:
- Stock funds. Stock mutual funds, or equity funds, invest in a group of stocks. As with buying individual stocks, this type of mutual fund has greater financial risk given the stock market’s fluctuations.
- Bond funds. Bond funds invest in bonds. Bonds are a kind of debt issued by companies or the government as a tradable asset. Investors who buy the bonds are essentially lending out their money, and they are paid interest in return. These funds carry a lower risk than stock mutual funds.
- Balanced funds. Balanced mutual funds invest in a variety of securities, from stocks and bonds to certificates of deposit (CDs). They aim to maximize value while reducing risk by diversifying in a number of assets.
- Money market funds. Money market funds have lower risk than other mutual funds and purchase short-term debt issued by the government, banks, or corporations.
- Target-date funds. Target-date funds account for your age, investing aggressively when you’re younger, and theoretically can take on more risk, then making safer bets on bonds and the like as you near retirement.
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