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What is a Mutual fund and How Does it Work?

Regardless of what kind of investor you are — small or large, aggressive or conservative, or somewhere in between — mutual funds offer you diversification at a lower cost, this is often with the added benefit of professional management. For those reasons, mutual funds are one of the most popular investment vehicles for the majority of investors. So let’s take a look at what mutual funds are, and why you should consider them as part of your overall investment strategy. And before you make any investment decisions, seek out a trusted professional for investment advice.

what is mutual fund and how does it work

What are Mutual Funds?
Ask any investment professional for investment advice, and they’ll tell you the best way to reduce your risk is by diversifying. You’ve no doubt heard the expression, “Don’t put all your eggs in one basket.” That adage is absolutely true for investing.

Instead of putting all your money into one type of industry, or one investment vehicle, mutual funds allow you to spread your risk by buying stocks from many different companies in dissimilar sectors. And with more than 9,000 mutual funds available holding $16 trillion in assets, you should be able to find a mutual fund that fits your investment strategy.

When you buy mutual funds, a professional investment manager takes money from many individual investors and pools it all together in one large pot. That professional manager then invests that pool of money into different types of assets — stocks, bonds, commodities, and even real estate. The combined holding of the fund is known as its portfolio.

You, the investor, now own shares, which represent a portion ownership of the assets owned by the fund. Something to note is that because of their fee structures, mutual funds are aimed at longer-term investors and aren’t designed to be traded frequently. 

A Helpful Mutual Funds Analogy
When you’re thinking about what mutual funds are and how they work, think of mutual funds like this: Let’s pretend you want to invest in a town by buying an entire neighborhood (in this analogy, the neighborhood is the mutual fund’s portfolio). There are lots of different houses in this neighborhood; some are big, some are small. Some houses are fancier while others are more modest. And in this analogy, the houses represent the individual assets inside the mutual fund.

You go to someone who knows neighborhoods and real estate (that’s the investment manager). Now, a neighborhood is a big and expensive purchase. So you know there are other people buying part of this neighborhood, too. (Those other people are fellow investors who are also buying that mutual fund.)

By buying this neighborhood instead of just one house, you know you’re spreading the risk around. Some of these houses are more valuable than others. Some may need to be fixed up or torn down, while others may be in great shape as-is. You may, or may not, know all of the types of houses you have in the neighborhood (again, the portfolio), but you know you’re not taking too big of a risk by buying all fixer-uppers. That’s diversification.
That’s basically what a mutual fund is.

How Do Mutual Funds Make Money?
All funds carry some risk — which is why we diversify. But generally, when you buy into a mutual fund, your investment can increase in three ways:
  1. Dividend payments are when a company makes a profit and distributes those profits to its eligible shareholders. You can choose to have your share of the dividends reinvested into the fund or receive your distributions (though you’ll have to pay taxes on the dividends).

  2. Capital gains are when a fund sells a security that’s gone up in price; if it goes down in price, it’s a capital loss, which you may be able to deduct from your taxes. Most funds distribute any capital gains annually to their investors.

  3. Net asset value, or NAV, is the price per mutual fund share. It’s calculated by adding up the total value of all the cash and securities in a fund’s portfolio, minus any liabilities, and then dividing that by the number of outstanding shares. The NAV calculation is important because it tells us how much one share of the fund is worth. So as the value of the fund goes up, so does the price to buy shares in the fund (the NAV per share).

We Can Help Find the Best Mutual Funds for You.
At First National Bank and Trust, our goal is to get you on a path toward a more secure financial future. That may begin with a conversation with one of our investment advisors, who will work with you to identify what investments are right for you.

There’s no better time than today to get started. Learn more about our mutual funds brokerage services or find a location that’s close to you.