Mutual funds are probably the single greatest investment for Middle America next to purchasing your own home. By their very nature they are a relatively "safe" investment, offering the greatest rewards for the least amount of risk; however, not many people understand exactly how they work. Mutual funds are the answer for the average person's desire to invest in the stock market, whereas most people do not have the skill, time, or temperament to make correct or educated choices concerning what and when they invest in; the mutual fund company does.

Think about it, by investing in a mutual fund company you are literally hiring your own team of money specialists - and not just any team of money specialists, these guys have years of education and experience; degrees from some of the best universities, they are men and women who have spent many years building and running models and market analysis, hedge funds, and finances; who spend their entire working day thinking about how money works - how your money works, and how to make it work harder. You may be a professional in any sort of field: doctor, lawyer, teacher, plumber, homemaker, etc. However, these guys are professional money managers. They know the inside scoop and how it works.

Mutual funds have historically outperformed most other investments, generating far greater return than what a typical CD in the bank or other savings institution can offer; in fact many have generated long-term returns of 18% and more. You may think that the effort involved to learn more about mutual funds or the hassle of finding one you are comfortable with isn't worth the difference in the rate of return you may realize, or that the rate of return is "only a few interest points higher," but that thinking is the difference between living self-sufficient in the golden years and depending on a supplemental job of flipping burgers somewhere to make ends meet.

How Do Mutual Funds Work?

The key to understanding how mutual funds work is in understanding the difference between rate of return and interest. A rate of return is the realized difference in value from an "investment;" it could be a positive return if you realize a gain, or it could be a negative return if you realize a loss. When you speak of interest you need to think of "loan;" you loan your money to the bank so that they can invest it in the market place to hopefully realize a gain, and in return for the use of your money they pay you an interest rate. Mutual funds do not pay interest rates because you are not giving, loaning, or depositing your money with them for them to use; instead, you are purchasing a part of their company, you are becoming an owner and hold an interest in their company - you are an "owner, not a loaner."

This is how it works: Let's assume that a popular company is offering its shares to the public for over $100 a share. To the average American they would not be able to purchase very many shares of that company and still have enough money left over to be able to diversify their investments. A good rule of thumb is to always diversify, or as the old saying goes, "don't put all your eggs in one basket." There are some companies today whose stock are worth thousands of dollars a share - average folk just don't buy these kinds of shares. So, how does a person be able to purchase a wide variety of shares investing in a good cross-section of America with limited amounts of money? Enter mutual funds. Mutual funds have millions and even billions of dollars that enable them to purchase hundreds of thousands of shares of these kinds of companies, as well as many other companies, giving them a portfolio representing a good, balanced cross-section of different kinds of companies and economy. They obtain this money from investors like you and me who purchase shares of the mutual fund company - we become part owners of the mutual fund company that owns lots of shares of lots of other companies. The shares of the mutual fund company are much more manageable for middle-income earners to afford and offers them the advantage of being widely diversified in a number of solid companies in numerous industries. The performance of the mutual fund company is reflected in their earnings and dividends as well as the value of their shares.

How Do I Make Money With a Mutual Fund?

There are a few of ways you can realize a gain with a mutual fund company; one way is you can receive dividends from the mutual fund company. When a company does well it will reward its shareholders by distributing the gains. This comes in the form of dividends. Since the mutual fund company owns thousands of shares from scores of different companies, they are in fact a part owner, or shareholder of those companies and as such will receive dividends from them; since you are a part owner of the mutual fund company those dividends will be passed on to you.

Another way you can realize gain is when the mutual fund makes short or long term gains. Lets say that the mutual fund company you invest in bought several shares of a company for $100 a share and after six months those shares are no worth $200 a share. Based upon the mutual fund company's models and research they believe that the company has now reached its peak and so the mutual fund company sells those shares and realizes a profit or gain of $100 a share. They will pass these earnings on to you as gains; whether the gain will be characterized by short or long will depend on how long the mutual fund company held the stock before they sold it.

A third way to realize a gain or profit from the mutual fund company is if you share your shares of the company that you bought. Assume that you purchased 100 shares of a mutual fund company at $25 a share, and that the company does real well with their investments, which is reflected in their price per share climbing to $75 per share and you sell some of your shares. You will have realized a gain on your investment and shortly after you sell your shares the company will mail you a check for the amount of your profit.

It is important to understand that even though a mutual fund has great diversification, professional money managers, and many checks and balances it is still a part of life that you could lose money. The value of your mutual fund will reflect the value of the companies it invests in; for this reason you must be careful and invest in the kind of mutual fund you feel most comfortable with.

What Kinds of Mutual Funds Are Available?

Mutual funds typically offer a variety of funds to meet a wide variety of investors and their goals. The kinds of funds offered range from very low risk funds such as municipal bond funds to much more speculative funds such as international growth funds, or small business funds. There is usually a fund to meet almost every criteria and goal you may have. A good rule of thumb is this: when purchasing mutual funds and you will want to get to the money quickly or only after a short term of a few years, then invest in stable, low-risk funds; if you have time on your side and do not have to have the money to depend on any time soon, and can wait up the natural ups and downs of the market, then a little higher risk fund may be appropriate for you to invest in. Remember this: the greater the potential return, the greater the risk involved, the lower potential for return the lower the risk involved - there is such a thing as "healthy" risk. Your investment counselor can help you determine what will work best for you.

How to Make Mutual Funds Work Harder!

When you put the power and strength of a mutual fund to work for you, then you want to keep as much of it as possible for your future benefit. That is when setting your mutual fund investments as tax shelters can help. That's right, you can set almost anything up as a tax shelter, all it takes is the simple stroke of the pen to check the right box an the application form for your mutual fund.

Think of standing out in a rain shower with an open umbrella protecting you from getting wet; that is what tax shelters are like: open umbrellas protecting any savings vehicle, including mutual funds, from getting wet by taxes. You can have two identical mutual funds but set one up under the protection of a tax shelter program of your choice - one will be taxed on its growth as any other investment income would, where the other will be protected from taxes depending on the kind of tax shelter you establish. Talk with your investment counselor to determine which of the many tax shelter options available today may be right for you.

The Magic of Dollar-Cost Averaging

Probably the easiest and best way for Middle America to invest in mutual funds is to take advantage of what is called dollar-cost averaging. Simply put, dollar cost averaging buys you the most shares for the least amount of cash outlay over a given period of time. It only works, however, when you regularly and consistently invest, for example on a monthly basis.

This is how it works; assume that you have the choice between two investments: choice #1 you invest $600 dollars by purchasing shares of XYZ Corporation at $10 a share, and in six months your investment is now worth $20 a share -- you have realized a 100% return on your investment; or, choice #2 you invest $100 once a month for six months (same $600 investment) in 123 Corporation that starts at $10 a share but in the course of time drops to $2 but then only manages to get back up to where it started at in the beginning at $10 a share. Which do you choose? Most people would pick choice #1 because they easily see the 100% return. This is where the magic of dollar-cost averaging comes into play.

Look at choice #2 a little more closely; in our scenario you are going to invest $100 a month for six months compared to a one-time investment of $600. The following tables, although very simple, help demonstrate the principle of what happens: