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Mutual Funds Basics


Once you've decided to invest in the stock market, mutual funds are an easy way to own stocks without worrying about choosing individual stocks. As an added bonus, you can find plenty of information on the Internet to help you learn about, study, select, and purchase them.

But what is a mutual fund? It's not complicated. A dictionary definition of a mutual fund might go something like this: a single portfolio of stocks, bonds, and/or cash managed by an investment company on behalf of many investors.

The investment company is responsible for the management of the fund, and it sells shares in the fund to individual investors. When you invest in a mutual fund, you become a part owner of a large investment portfolio, along with all the other shareholders of the fund. When you purchase shares, the fund manager invests your funds, along with the money contributed by the other shareholders.

Every day, the fund manager counts up the value of all the fund's holdings, figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that day. If you want to buy shares, you just send the manager your money, and they will issue new shares for you at the most recent price. This routine is repeated every day on a never-ending basis, which is why mutual funds are sometimes known as "open-end funds."

If the fund manager is doing a good job, the NAV of the fund will usually get bigger -- your shares will be worth more.

But exactly how does a mutual fund's NAV increase? There are a couple of ways that a mutual fund can make money in its portfolio. (They're the same ways that your own portfolio of stocks, bonds, and cash can make money).

  • A mutual fund can receive dividends from the stocks that it owns. Dividends are shares of corporate profits paid to the stockholders of public companies. The fund might have money in the bank that earns interest, or it might receive interest payments from bonds that it owns. These are all sources of income for the fund. Mutual funds are required to hand out (or "distribute") this income to shareholders. Usually they do this twice a year, in a move that's called an income distribution.
  • At the end of the year, a fund makes another kind of distribution, this time from the profits they might make by selling stocks or bonds that have gone up in price. These profits are known as capital gains, and the act of passing them out is called a capital gains distribution.
Unfortunately, funds don't always make money. If the fund managers made some investments that didn't work out, selling some investments for less than the original purchase price, the fund manager may have some capital losses.

Everyone hates to have losses, and funds are no different. The good news is that these losses are subtracted from the fund's capital gains before the money is distributed to shareholders. If losses exceed gains, a fund manager can even pile up these losses and use them to offset future gains in the portfolio. That means that the fund won't pass out capital gains to shareholders until the fund had at least earned more in profits than it had lost. (Although you might want to reconsider your decision to remain invested in a fund that's losing money if the rest of the market is growing).