Owning a few shares of a bunch of different companies. You could buy 200 shares of Microsoft or you could buy a couple shares of a bunch of different companies. Think of it this way: If you put all your eggs in one basket and drop it then you lose all you’ve lost everything but if you distribute your eggs into a number of different baskets then dropping one basket doesn’t cost you much. This is what a Mutual Fund does, it lets you buy a bunch of different stocks with a bunch of different people.
This is your personal outlook on loss. How much could you stand to lose before it became too much for you? Don’t invest in a hot stock if it will keep you up at night because you are worried that it went down 10 cents yesterday. Knowing how much risk you are willing to take before investing is extremely important.
The purpose of dividends is to share the profits with shareholders. Example: I own 12 shares of Boeing stock. Every quarter they share their profits with me. It isn’t very much, around $18.00 a year, but that’s because I don’t own much. The real power comes from reinvesting the dividends.
When dividends are issued you have two options: Cash the check or re-invest. In my example of 12 shares of Boeing, I could simply deposit the money in my checking account or I could use that money to buy another share of Boeing stock. I chose to re-invest because of the power of compounding.
Think of a fly-wheel: Once the wheel starts turning then it is easier to turn it more and the wheel goes faster. Another example would be peddling a bike: It takes more energy to get a bike to start moving but once you get going it doesn’t require much more of your energy to make it go faster. This is similar to how Compound Interest works.
Another example would be:
You put $5,000.00 into savings that earns 1% a year ($50.00). At the end of one year you would have a total of $5,050.00. Allow that money to compound again and your $5,050.00 would grow $50.50, giving you a total of $5,100.50. The next year your investment would grow $51.00, giving you a new total of $5,151.50. Let that money ride without adding anything to it and you will have $5,468.43 in 10 years and $7,370.61 in 40 years! That’s compounding interest.
I won’t go into detail about expenses, these are simply the cost of buying or managing the account.
Capital Gains Tax
No discussion about investing would be complete without addressing taxation. You must understand Capital Gains tax. Currently, capital gains are taxed at a maximum of 15%. In other words, if your mutual fund realized a gain of $1,000 last year then you would pay $150 in income tax.
Did you ever have something happen and then later you “realized” what it was? The same term can be used when describing profits from shares of stocks that you earn interest or income from, including dividends. Receiving income, interest, or dividends from an investment portfolio must be “realized” and included in your income tax return. Note: You do not realize capital gains from investments such as 401k, ROTH IRA, or similar accounts with tax-deferred status.
Mutual funds are an easy way to put money away for the future, are less risky than single stocks, and have a history of much greater growth than bonds.