Understanding Stock Funds In Stock Market

6.1 Stock Market Investing

Most stock market investors who make money do so not because they’re smarter, luckier, or more clairvoyant than anyone else. They make money by simply being more patient and by using three simple investment methods:

• Invest in a diversified portfolio of stocks.
• Continue to save money and add to investments.
• Don’t try to time the market.

A small number of extraordinary investors – Warren Buffett being a famous one who’s frequently in the news – generate exceptional returns. Buffett and these other elite investors do the above three things and have a talent for identifying and investing in undervalued businesses before most others see that value. The good news for you is that you can earn handsome long-term stock market returns without having Buffett’s talent.
People who get soaked in the stock market are those who make easily avoidable mistakes. An investment mistake is a bad decision that you could’ve or should’ve avoided, either because better options were available, or because the odds were heavily stacked against you making money. Investment mistakes result from the following:

• Not understanding risk and how to minimize it
• Ignoring taxes and how investments fit into overall financial plans
• Paying unnecessary and exorbitant commissions and fees for buy-and hold investments
• Surrendering to a sales pitch (or salesperson)
• Trading in and out of the market

The stock market isn’t the place to invest money that you need to tap in the near future (certainly not money you need to use within the next five years). If your stock holdings take a dive, you don’t want to be forced to sell when your investments have lost value. So come along for the ride – but only if you can stay for a while!

6.2.The Stock Market Grows Your Money

Stocks represent a share of ownership in a company and its profits. As companies (and economies in general) grow and expand, stocks represent a wonderful way for investors to share in that growth and success. Over the last two centuries, investors holding diversified stock portfolios earned a rate of return averaging about 10 percent per year, which ended up being about 7 percent higher than the rate of inflation. Earning such returns may not seem like much (especially in a world with gurus and brokers claiming returns of 20 percent, 50 percent, or more per year). But don’t forget the power of compounding: At 10 percent per year, your invested dollars doubles about every seven years. The purchasing power of your money growing 7 percent more per year than the rate of inflation doubles about every ten years.

Contrast this return with bond and money market investments, which have historically returned just a percent or two per year over the rate of inflation. At these rates of return, the purchasing power of your invested money takes several decades or more to double.

Your investment’s return relative to the rate of inflation determines the growth in purchasing power of your portfolio. What’s called the real growth rate on your investments is the rate of return your investments earn per year minus the yearly rate of inflation. If the cost of living is increasing at 3 percent per year and your money is invested in a bank savings account paying you 3 percent per year, you’re treading water – your real rate of return is zero. (On the top of inflation, when you invest money outside of a tax-sheltered retirement account, you end up paying taxes on your returns, which could lead to a negative real “growth” in your money’s purchasing power!)

6.3 Using Mutual Fund to Invest in stocks

Mutual funds are the way to go when you want to invest in stocks. The best stock funds offer you diversification and a low-cost way to hire a professional money manager. They help in Reducing risk and increasing returns.
When you invest in stocks, you expose yourself to risk. But that doesn’t mean that you can’t work to minimize unnecessary risk. One of the most effective risk-reduction techniques is diversification – owning numerous stocks to minimize the damage of any one stock’s decline. Diversification is one reason why mutual funds are such a great way to own stocks. Unless you have a lot of money to invest, you can only cost-effectively afford to buy a handful of individual stocks. If you end up with a lemon in your portfolio, it can devastate the returns of your better-performing stocks. Companies go bankrupt. Even those that survive a rough period can see their stock prices plummet by huge amounts – 80 percent or more – and sometimes in a matter of weeks or months. Of course, owning any stock in a company that goes bankrupt and stays that way means that you lose 100 percent of your investment. If this stock represents, say, 20 percent of your holdings, the rest of your stock selections must increase about 25 percent in value just to get your portfolio back to even.
Stock mutual funds reduce your risk by investing in many stocks, often 50 or more. If a fund holds 50 stocks and one drops to zero, you lose only 2 percent of the value of the fund if the stock was an average holding. If the fund holds 100 stocks, you lose 1 percent, and a 200-stock fund loses only 0.5 percent if one stock goes. And don’t forget another advantage of stock mutual funds: A good fund manager is more likely to sidestep investment disasters than you are. Another way that stock funds reduce risk (and thus their volatility) is by investing in different types of stocks across various industries.
Different types of stocks don’t always move in tandem. So if smaller-company stocks are being beaten up, large-company stocks may be faring better. If growth companies are sluggish, value companies may be in vogue. You can diversify into various types of stocks by purchasing several stock funds, each of which focuses on different types of stocks. This diversification has two potential advantages. First, not all your money is riding in one stock fund and with one fund manager. Second, each of the different fund managers can focus on and track particular stock investing opportunities.

6.4 How Stock Funds Make Money?

When you invest in stock funds, you can make money in three ways:

o Dividends: Some stocks pay dividends. Many companies make profits and pay out some of these profits to shareholders in the form of dividends. Some high-growth companies reinvest most or all of their profits right back into the business. As a mutual fund investor, you can choose to receive your fund’s dividends as cash or reinvest them by purchasing more shares in the mutual fund. Unless you need the income to live on (if, for example, you’re retired), reinvest your dividends into buying more shares in the fund. If you do this outside of a retirement account, keep a record of those reinvestments because those additional purchases should be factored into the tax calculations you make when you sell the shares.

o Capital gains distributions: When a fund manager sells stocks for more than she paid for them, the resulting profits, known as capital gains, must be netted against losses and paid out to the fund’s shareholders. As with dividends, your capital gains distributions can be reinvested back into the fund. Gains from stock held for more than one year are known as long-term capital gains and are taxed at 20%

o Appreciation: The fund manager isn’t going to sell all the stocks that have gone up in value. Thus, the price per share of the fund should increase (unless the fund manager made poor picks or the market as a whole is doing poorly) to reflect the gains in unsold stocks. For you, these profits are on paper until you sell the fund and lock them in. Of course, if a fund’s stocks decline in value, the share price depreciates. Hold the fund for more than one year and you qualify for low long-term capital gains tax rates when you sell.

If you add together dividends, capital gains distributions, and appreciation, you arrive at the total return of a fund. Stocks (and the funds that invest in them) differ in the proportions that make up their total returns, particularly with respect to dividends.