Q: How does my money grow if I invest in a mutual fund? Does it earn interest, like my bank account?
A: While a deposit in the bank will earn you interest, an investment in a mutual fund can earn you money two different ways – by growth or by income. Before understanding how your investment grows, it is important to understand how a mutual fund works.
A mutual fund is first and foremost an investment company, in the business of pooling together small (or large) sums of money from many different investors. As the money is collected, a professional money manager buys stocks and bonds with that money and issues shares to the investors.
As a shareholder in the investment company, your investment can increase in one of two ways. The shares that you bought for $10 could increase to $12. This growth in share price is also known as capital appreciation and occurs because the value of the stocks in the mutual fund have increased.
If you sell your shares for more than you paid for them, your profit is called a capital gain. The gain on this sale of your investments is taxable income upon which you pay a capital gains tax. If, however, you sell your shares for less than you paid for them, this is called a capital loss. The good side of this bad news is that declaring a capital loss on your tax return can reduce the tax you owe in April.
In addition to the possible growth of your investment, a mutual fund may pay you income. As the stocks and bonds in your mutual fund pay dividends and interest, a portion of those cash earnings is distributed to you as a shareholder. You could choose to have this income sent to you in cash, or you could choose to reinvest those distributions and purchase more shares in the mutual fund. But no matter what you choose to do with those earnings, it does represent taxable income that Uncle Sam likes to know about.
Whether your mutual fund invests in stocks or bonds, mutual funds are an investment which offers no guarantees and will fluctuate in value. But unlike a dollar deposited in the bank, which will forever stay a dollar, a mutual fund offers a greater opportunity for growth and income over the long run … though there is no guarantee.
D. DRUMMOND OSBORN, CFP is a Certified Financial Planner and Director of Wealth Management at Osborn Wealth Management, a Registered Investment Advisor, where he focuses on investment management, retirement planning and trust advisory services. Visit him at www.osbornwealthmanagement.com or e-mail him your questions or comments at drummond@osbornwealthmanagement.com.
