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What Are Mutual Funds?

When the market is down, your monthly investment typically buys you more shares of the fund, helping to increase your ownership in the fund. When the market is up, your monthly investment typically buys you fewer shares of the fund, helping you avoid buying too many shares at higher prices. Over a long period of time, the end result is that the average cost of your fund shares is lower than the average price of the fund shares during the same period.

Earning money

Once your money is in a fund, it can provide you with earnings in three ways.

  • Appreciation: The value of a fund share can appreciate or go up in value. (Of course, it can also go down in value.) When the total value of the securities owned by the fund rises, the value of your fund shares rises with it. Again, the reverse is also true.
  • Dividends: If the fund receives dividends from stocks, interest from bonds, or other investment income, it distributes those earnings to shareholders as a dividend according to the terms outlined in its prospectus. Depending on the fund, these distributions can be monthly, quarterly, or annually.
  • Capital gain distributions: Every time the fund manager sells securities at a profit, the fund earns capital gains. Funds are required to distribute these gains to the shareholders at regular intervals, typically once or twice a year. You can choose to have the fund automatically reinvest the money in more fund shares, keep it as cash in your account, or send the money to you.

Choosing a Mutual Fund

Choosing the right funds—and trusting your decisions enough to back them with your money—is challenging. To keep from getting overwhelmed, be sure you understand what you want for your money (protection, income, growth), then look only at the funds that aim for the same thing. But where can you look for information?

Look at the fund prospectus

The prospectus is essentially the user's manual for a mutual fund. While known for being dense, recent changes in regulations require them to be easier to read. Simply looking at the charts and tables in the first few pages will tell you a lot you need to know. The SEC requires every fund to publish a prospectus and update it annually. It covers all of the important elements, such as the history, management, financial condition, performance, expenses, goals, strategies, types of allowable investments, and policies.

Use independent rating services

Independent rating services, such as Morningstar and Lipper, provide a convenient way to find out information about a fund very quickly. These services typically provide you with a rating or ranking of a fund based on its performance relative to its broader peer group, as well an opinion about a fund's management team and operations. When you subscribe to a service, you may get access to a wide range of information and services, depending on your subscription level. Tools and resources typically include access to fund ratings or rankings, computer-based guides, educational materials, and monthly and quarterly newsletters.

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