Mutual funds: What is it? How does it work & how to invest
Mutual funds investment is one of the best investment tools for those who are looking to grow their money. If you’ve been thinking about adding mutual funds to your investment portfolio, it’s a good idea to get some information on the subject to make sure you select the option that’s right for you.
Hence, keep reading this article because it covers everything you need to know about mutual funds; what they are, how they work, and how to invest in them, among other aspects of interest.
What are Mutual Funds? (Definition)
A Mutual Fund is an alternative savings and investment instrument where the money (contributions) subscribed by different people (investors) is pooled through a Mutual Fund Management Company that invests it in different financial instruments such as stocks, bonds, or money both in national and international markets, seeking to make it grow, allowing the client to choose the mutual fund that best suits their objectives.
How do Mutual Funds work?
In mutual funds, the fund manager decides what to include in the mutual fund and when to buy and sell securities. For people who don’t have the time, education, money, or desire to manage a large investment portfolio, mutual funds are a great option.
Are Mutual Funds a good investment?
For many people, mutual funds are a better investment choice than individual stocks and bonds for the following reasons:
- They offer a generally more attractive return than other traditional savings products.
- The availability of money is fast, with minimum periods of permanence depending on the mutual fund chosen.
- Without having technical knowledge, you will be able to access the local and international Capital Market, since financial entities have investment experts who constantly monitor market conditions and the investment opportunities they require.
- Mutual funds are relatively affordable and allow you to buy hundreds of stocks at a relatively low cost.
How to invest in Mutual Funds
Here are steps to successful investment in mutual funds:
1. Identify your goals
The first step to take when deciding to invest in mutual funds is to identify exactly your goals.
What you need to do is ask yourself “What are the financial goals I want to achieve through this investment? And are these goals short-term or long-term? “
If you are investing for a long-term goal, such as retirement, mutual funds are a great choice. In fact, mutual funds have among their characteristics a low level of risk but also a low return, which begins to become significant only after years in which your capital has remained “parked” in this asset.
Plus, by investing over the long term, mutual funds have plenty of time to overcome the inevitable ups and downs of the markets.
But, if you are saving for a short-term goal, then probably the only type of mutual fund that could be right for you is the bond one.
2. Define the right strategy
Once you understand what your investment goals are and what is the time horizon in which you want to move, you need to choose a strategy that respects these goals.
For example, if you have long-term goals you should allocate between 70% and 100% of your budget dedicated to this type of asset, in equity-based funds. Or, if you don’t want to invest that heavily in stocks and have a medium-term goal, you might prefer an approach that reduces the possibility of rapid changes in the value of your investment.
3. Learn to recognize the different classifications and types of mutual funds
Based on the instruments they invest in, mutual funds can be classified as equity, bond, balanced, real estate, etc.
Based on the subscription and redemption procedures, however, mutual funds can be divided into:
- Open: they allow the redemption of the shares at any time according to the procedures provided for, in the contract.
- Closed: they give the right to subscribe for the new units issued or to redeem them exclusively by respecting predetermined deadlines.
Finally, mutual funds can also be classified as:
- Harmonized: they are required to comply with all investment regulations to contain risks and safeguard investors.
- Not harmonized: although they have to comply with investment rules, they are subject to less stringent rules that leave more room for maneuver, thus allowing more chances of gain but also greater risk.
4. Choose the best mutual funds
Once you have defined your strategy, if you are convinced that mutual funds are the best type of asset for you, it is time to specifically choose one or more funds to bet on.
To choose which instrument to bet on, I recommend that you consider these aspects:
- Past performance: Even though a fund’s performance in the past may not give full assurance of its future prosperity, it can be reasonable evidence of its capacity to accomplish its goals.
- Expense reports: These are annual fees that compensate the fund managers and cover the purchase costs of the fund’s investments. You should pay attention to this because they have a big influence on how your money grows over time.
- Loading fees: These are the broker’s commissions for selling to you a mutual fund. Mutual funds are often also categorized as “load” or “no-load” funds. The former applies commissions, while the latter does not. Obviously, my advice is to always prefer the latter.
- Management: mutual funds are actively managed, meaning the company you bought them from will make periodic improvements and changes to the fund to maximize its results. To carry out this activity, the fund manager requires the payment of a fee, so I recommend that you compare the management costs of different funds to find the most convenient one.
5. Choose how to invest in Mutual Funds
There are several possibilities for investing in mutual funds. You can contact:
- A bank branch
- Networks of financial advisors
- Asset management company
- Online platforms such as sites for the purchase of financial products or home banking
In general, the choice of the different distribution channels depends on the specific needs of the investor.
If you want to do it yourself and use online platforms to avoid paying management fees, make sure you have the skills to do it. You need to be able to assess the riskiness of the underlying assets of the fund you want to bet on and the suitability of the product for your risk profile.
If, on the other hand, you are a novice investor, it will probably be more advantageous for you to contact an intermediary who will be able to guide you in your investment. In this way, you can get help to better understand the functioning of the markets and funds and the characteristics of the products you are purchasing.
6. Define an exit strategy
At the end of the time frame you have set, you will want to sell your mutual fund shares to meet your financial goals, such as withdrawals during retirement.
You will probably have to pay a commission to the fund management company to collect the shares and once you have collected them you will have to pay some taxes.
Before liquidating your investment, it is good to consider all these costs, to avoid unnecessary eroding of your profit.
One idea might be to speak to a financial advisor or tax professional to determine the strategy for minimizing the taxes you may have to pay on your investments.
Now that you know more about mutual funds, keep what you have learned in mind when looking for one and acquiring the best one for you.
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