Do you worry about your teen or 20-something’s financial choices? Although the world of investing may be second nature to you at this point in your life, often teens and even college grads don’t understand anything about investing. Having worked around my fair share of fiscally-clueless twenty-somethings, I am no stranger to explaining things in ways they will understand. So, before your offspring go out and waste away their first real-world earnings, have them read this brief overview on mutual funds. I’ll cover everything from the different types, to knowing when you should and should not invest. Before we get to mutual funds though we need to discuss passive income.
What is Passive Income?
According to the Internal Revenue Service (IRS) passive income is defined as “income from trade or business activities in which you do not materially participate.” In other words it is income from investments, royalties, rental income, etc.,—anything where you are not directly trading hours for dollars.
In a nutshell, passive income is a way for you to make your money work for you. If you personally work longer hours it will add to your wealth, but you only have so many hours a day. Passive income, on the other hand, is the only way to multiply your wealth because each dollar earns more dollars and it can continue to compound more and more. Your money works for you, while you’re in class, work, or even at the gym.
Mutual Funds are one method of generating passive income. Mutual funds are operated by professional money managers and are usually a great investment choice for college students and recent grads, because you do not have to be an expert in investing to use them. Someone who is familiar with all forms of investing handles the actual investment choices.
However, it’s important still to have a working knowledge of what they are so you can make better, more informed decisions. When making sense of this complex subject, the best place to start is with understanding how they are structured.
First off, you should know the components of a working mutual fund. There’s the fund manager, who oversees the movement and behavior of the funds. He is the one in charge of protecting the shareholders’ assets and plays a large role in the return on investment individuals earn. The next biggest difference between various mutual funds is the actual assets that the fund invests in—either cash, stocks, bonds, etc.—that holds value to the investors. This is what the fund manager manages. Additionally, a mutual fund also contains a contract that delineates everything from who will directly handle your investments to how and when you get your dividend check. This contract will tell you what the fund is allowed to invest in. For instance one fund might only invest in large companies, another might only invest in small companies or foreign companies or companies in a particular industry, etc.
Types of Mutual Funds
Now that you understand the main structure of a mutual fund, you can begin to learn the many different types of them that are available to you. From fixed-income to money-market and equity, the types of mutual funds are far and wide. The three major types of mutual funds are (from least risky to most risky):
- Money Market Mutual Funds
- Fixed income Funds
- Equity Funds
Money market mutual funds, invest mostly in Treasury bills and other Government obligations and although it is very stable, you won’t necessarily get great returns.
Similarly, “fixed-income” funds invest in Bonds are also a reliable source of earnings for investors, hence its name—meaning it supplies a steady flow of income for the shareholder.
Finally there are equity funds that invest in the stock aka. “shares” of a company.
Since there are so many variations of these types of funds, we’ll leave it at that, but should you consider investing be sure to do your homework, which brings me to my next point.
Choosing and Investing in a Fund
The type of fund you choose to invest in depends greatly on what your financial goals are. If you’re looking to earn high returns, you should invest in a stock fund. But do remember, with great return comes the potential for great risk, so there’s always the chance you’ll lose money with this option.
For a more steady, consistent pay-out, you might channel your money toward a bond fund, as their behavior is much less erratic than that of stocks. Then there are the funds that invest in both stocks and bonds, providing shareholders with a little bit of everything, these are called “Balanced” funds .
When deciding on which mutual fund is right for you you might also consider an “index” fund. Index funds mimic an index like the S&P 500 or the Dow. This way your personal portfolio will be much like what you read in the paper. Index funds usually charge lower management fees because they don’t have much work to manage them. They simply balance it to match the index and don’t have to analyze stocks to decide which stocks to add or subtract from their holdings.
After absorbing all of this, your mind might be spinning with one thought—go out and invest, but before you do, this article has hardly made you an expert on the subject. So, before you do anything, READ UP about your various options and also, be honest about your financial situations. Investing isn’t for everyone right away. If you are still unsure about what you should do, consider scheduling an appointment with a financial advisor or someone else in the fiscal world you trust, to get an accurate picture of what your choices are. Don’t do anything too rash—after all this is YOUR money we’re talking about.
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