A vast majority of Americans have invested in mutual funds, mostly through a 401(k) plan at work, a Roth IRA, a Traditional IRA, a 403(b), a SEP-IRA, a Simple IRA, or another retirement account. Unfortunately, many new investors can't actually tell you what a mutual fund is, how a mutual fund works, or how you make money from a mutual fund. This brief introduction to making money from mutual funds was designed to help you answer those questions.
You Can't Start Making Money Investing in Mutual Funds Until You Understand What They Are
Before you can learn how to make money investing in mutual funds, you have to understand what a mutual fund is. I put together an extensive resource to help you understand this called The New Investor's Guide to Mutual Fund Investing. One of the articles in that series was called How a Mutual Fund Works. To save you time, I'll give you the short version.
Basically, a mutual fund is a term used to describe a type of company that doesn't do anything itself, but rather it owns investments. The company (the mutual fund) hires a portfolio manager and pays him or her a management fee, which often falls between 0.50% and 2.00% of assets. This portfolio manager invests the money raised by the fund according to the strategy laid out in a document called the prospectus.
Some mutual funds specialize in investing in stocks, some in bonds, some in real estate, some in gold. The list is practically endless. As I mentioned in Making Money Investing in Dividend Stocks, there are even funds designed for people who only want to own dividend stocks in the S&P 500 that have increased the dividend every year for the past 25 years! It is safe to say that there is a mutual fund for almost any objective you may wish to achieve.
The Ways You Actually Make Money from Owning Mutual Funds
How you start making money when you invest in a mutual fund depends upon the type of fund you own. If you own a stock fund, you already learned in Making Money from Investing in Stocks that the biggest sources of potential profit are an increase in the stock price (capital gains) or cash dividends paid to you for your pro-rata share of the company's distributed profits. If the fund instead focused on investing in bonds, you are making money through interest income. If the fund specializes in investing in real estate, you might be making money from rents, property appreciation and profits from business operations, such as vending machines in an office building.
The Three Keys to Making Money Through Mutual Fund Investing
There are three major keys to making money through mutual fund investing. These are:
- Keep expenses low. The number one consideration when it comes to making money from mutual funds is keeping your costs low. This is the reason so many financial advisers tell their clients to invest in low cost index funds. These are often referred to as "dumb money" because they have no portfolio manager. Instead, they hold a basket of stocks with similar characteristics, such as those belong to an index like the Dow Jones Industrial Average. Why is that important? Because saving even 1% over an investing lifetime can lead to enormous wealth. If an 18 year old saved $5,000 per year, the difference between a 7% return and an 8% return over 50 years is $836,206. That is real money by anyone's standards!
- Give yourself plenty of time to compound your wealth. The longer you money stays invested, the more time you have to capture the power of compound interest.
- Don't invest in anything you don't understand. The first rule of making money, as Warren Buffett has often quipped, is to never lose money. The second rule is to see rule #1. You should know exactly what each of your mutual funds owns and why you are invested in it.
More Information About Making Money from Mutual Funds
If you are looking for more information about making money from mutual funds, read How to Select a Winning Mutual Fund - A 10 Part Guide.