How Do Mutual Funds Work?

Financial AdviceJuly 7, 2023

Investing money is essential to financial planning, and mutual funds are among the most popular investment options. Many investors prefer mutual funds because they offer diversification of portfolios and professional management. However, mutual funds can be quite confusing for new investors due to their complex nature. Here’s a breakdown of mutual funds and what to expect when investing in them.

What Are Mutual Funds?

Mutual funds are investment vehicles that pool money from several investors and use the funds to invest in a diversified mix of stocks, bonds, and other securities. Professional money managers from the mutual fund company then make investment decisions for the fund, buying and selling securities to generate returns. Mutual funds often have various categories, such as equity, debt, hybrid, and sector-specific funds, each with its own investment strategy.

Kaiser/ iStock | you don’t need to be an expert in mutual funds. You need to find experts you can trust

How Do Mutual Funds Work?

When you invest in a mutual fund, you purchase a share or units of the fund. The fund’s net asset value (NAV) determines your share’s value or unit. The NAV is calculated by dividing the total value of all the fund’s investments by the number of outstanding shares or units. As the NAV of the fund’s portfolio appreciates, the value of your share/unit also increases. Similarly, when the NAV falls, the value of your share/unit decreases.

Types of Mutual Funds

As mentioned, mutual funds offer investors several categories based on their investment objectives. Equity funds invest in stocks, while debt funds invest in fixed-income securities like bonds and government securities. Hybrid or balanced funds invest in a mix of both stocks and bonds. There are index funds, which track a particular index, and ETFs, exchange-traded funds that trade on stock exchanges.

Vista/ Getty Images | Mutual funds are typically considered a safer investment than purchasing individual stocks

Costs Involved in Mutual Fund Investment

Investing in mutual funds incurs certain costs, including the expense ratio, which the fund house charges to cover its management and operation expenses. This fee is deducted from the fund’s NAV. Other costs may include transaction, redemption, and exit load fees levied when you sell your units within a specific period. Considering these expenses when selecting a mutual fund is crucial since they can significantly eat into your returns.

Factors to consider

Before investing in mutual funds, there are several factors to remember, such as your risk tolerance, investment goals, tax implications, and expense ratio. Remember that mutual funds work as a long-term investment, and risk and returns are involved. Always read the offer document, which contains information about the fund’s investment objective, risks, and fees.

AOA/ Shutterstock | The liquidity of mutual funds allows investors to buy or sell their shares easily

Why Invest in Mutual Funds?

Mutual funds offer various benefits, such as diversification, professional management, and liquidity. Investors can choose to invest small amounts periodically, making it ideal for those with a limited budget. Mutual funds also offer investors exposure to a wide range of securities and assets, significantly reducing the risk of loss compared to investing in individual securities.