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For example, people say “I’m invested in a mutual fund”, but what does that mean? How much money are you getting back?
What kind of interest are you getting, if any?
These kinds of confusions lead to a question like “How often are mutual funds compounded?”
What Is Compound Interest?
To answer this question we first need to know what compound interest is. To put it simply, compound interest is when interest builds upon interest over time. So a 10% compound interest rate would start with $1,000 becoming $1,100, like simple interest, but then it continues and $1,100 becomes $1,210 (10% of $1,100 being $110) and so on.
So any time interest is paid on your interest you are getting compound interest.
This is powerful, and even more so depending on when it is paid.
Your compound interest could be annually, semi-annually, monthly, or even daily. The more often your interest compounds the higher your return.
If your $1,000 compounds yearly, then you only get $100 in interest at the end of a year, but if it compounds daily you end up with $105.16. That might not seem like a big difference, but if you have thousands of dollars invested it really adds up.
As a side note, this is where mortgage companies get you. They advertised an interest rate, say 5%, but then they compound it monthly, so your interest paid by the end of the year is actually more than 5%.
The goal of investing, then, is to get compound interest to work in your favor.
But that’s not how Mutual Funds work.
What Is a Mutual Fund?
Setting aside mutual funds for a second, when you put money in a savings account, you are putting it into an interest bearing account.
So, however much you put in you are guaranteed to get a certain interest rate back.
It is usually quite small, but it is safe, which is partly why it is called a savings account.
A mutual fund, on the other hand, it not an interest bearing account. Let me restate that, you are not guaranteed a certain interest rate by investing in a mutual fund.
A mutual fund is a way of pooling your money with other investors to invest in a basket or group of assets (stocks, bonds, etc.) that is led by a fund manager who tries to get more money back on that investment through dividends and capital gains.
I try to keep things simple here, but unfortunately, mutual funds just aren’t that simple.
So to break that down, you probably don’t have enough money to make big investments, but if you pool money with a bunch of people you do, which is what a mutual fund does.
That money is used to buy a bunch of assets, usually stocks or bonds, but real estate stock called REITs are also an option among other things.
The person that decides what to invest in is called a fund manager. By buying into their fund you are trusting that they are doing the best they can to make you the most money.
And the way you make money is not interest, but dividends and capital gains.
A dividend is money that is paid back to the people that own portions of stocks (called shares) of certain companies when those companies make a profit. If you own some shares of a company that pays dividends, then you’ll get paid that money with the option to reinvest it into your mutual fund.
Capital gains is all of the money you make from selling a stock (or other asset) for more than you bought it for. For example, if you buy 10 shares at $5 (which equals $50) and they go up in value to $10 (which is a total of $100) and you sell, then you’ve made $50 in capital gains ($100 total minus the original $50 equals $50 in capital gains).
So, interest has nothing to do with how much you make in a mutual fund.
Do Mutual Funds Compound?
Since mutual funds pay out dividends or sell for capital gains, they don’t compound in the strictest sense of the word.
But, there are similarities.
Compound interest is compounding because it grows interest on interest. Much like that, you can reinvest your dividends into the mutual fund as they are paid out which has a similar effect of getting more dividends off of your dividends.
Capital gains, on the other hand, don’t compound but grow in proportion to how many shares you own vs how much the stock is worth.
This is annoying because the average person understands interest, but even basic investing doesn’t pay interest.
Fortunately, there is a way to convert interest and dividends or capital gains into the same unit of measurement to compare them. This is called return on investment.
Calculating a Mutual Fund’s Return On Investment
Return on investment is really easy to calculate, but if doing math makes you shake in your boots, try this online ROI calculator that is easy to follow instead.
Return on investment (ROI) is simply how much you’ve made on investing (you calculate this by taking what your investment is currently worth and taking away how much you originally invested) divided by how much you originally invested which is then turned into a percent.
So if you invest $100 and you have $110 at the end of the year you’ve had a 10% annual ROI ($110 – $100 = $10 of growth; $10 / $100 = .1 and that makes 10%).
The reason this is so helpful is because it doesn’t matter if you got $10 in interest of $10 in dividends, your annual ROI is still 10% which makes it easy to compare.
However, it is important to remember that while interest is fairly constant, dividends are intermittent and capital gains is a guessing game.
So while one year your interest might look really lame compared to the ROI of your dividends and capital gains, the next year it might look really good.
That is where all of the other investing jargon comes in like risk and reward, risk tolerance and blah blah blah.
We’ll get there later.
But now you can compare your expected ROI on a mutual fund with an interest bearing account like your savings account.
Fees: The Wealth Killer
Now that you understand how to calculate your return, there is one more thing to look out for.
Mutual funds often advertised based on their historical return. So they will say that historically their fund has made on average 6% or 4% per year, etc. But that isn’t your actual return on investment.
Each year the percent gain varies with the swings of the stock market, but the fees associated with that gain remain constant. Even if the fund loses money.
It is not uncommon for mutual funds to have 2% administration fees, meaning that the 6% or 4% gain is really 4% or 2% respectively.
In other words, the higher the fees the less money you make.
The only solution is to find a fund that has minimal fees. At most 1%. They are out there.
Picking The Best Funds
So what is the best fund? Honestly, probably not your average mutual fund.
Most mutual funds are run by a manager who actively chooses stocks and takes care of the portfolio.
While this sounds great, that means that there is a higher fee.
So what is the solution? Invest in the entire stock market of course!
Enter the Index Fund.
Index funds are incredibly simple. The index fund invests in a basket of assets (usually stocks) like a mutual fund. The difference is those assets aren’t chosen but they update automatically.
For example, if your index fund’s basket is all of the S&P 500 companies, every time that list of companies is updated then your index updates automatically.
You’ll get close to the average return of the entire stock market AND have minimal fees. Most companies charge under 0.5% on index funds. That means more money in your pocket.
Sometimes the investing options available through your company don’t offer an index fund.
That is okay, just remember that the lower the fees the better (in general), so use that as a starting point.
What advice have you found helpful in choosing a mutual fund? What are some other great investment options? Tell me about it in the comments below.
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A list of definitions used on this blog can be found here.
Compound Interest: when interest builds upon interest over time. So a 10% compound interest rate would start with $1,000 becoming $1,100, like simple interest, but then it continues and $1,100 becomes $1,210 (10% of $1,100 being $110) and so on.
Interest (Investing): Money returned on top of the original amount of money invested. For a very simplified example, if I invest $1,000 at a %10 interest rate than I can expect to receive $1,100 back.
Mutual Fund: A way of pooling your money with other investors to invest in a basket or group of assets (stocks, bonds, etc.) that is led by a fund manager who tries to get more money back on that investment through dividends and capital gains.
Stocks: Buying a certain percentage of ownership or “shares” in a company. The company uses the money received from selling shares to grow the company then pay back the owners of shares in the company with interest.
Bonds: To raise funds for a project an entity (usually a government) will sell bonds or certificates saying that if you pay X amount now you will get X back with interest later. This gives them the money they need now and gives the investor interest on their original investment later.
REITs (Real Estate Investment Trust): A way to buy stock or ownership in large real estate projects. They operate almost exactly like a stock, but with real property instead of companies determining the value of your shares.
Dividend: Money that is paid back to the people that own portions of stocks (called shares) of certain companies when those companies make a profit. If you own some shares of a company that pays dividends, then you’ll get paid according to how many shares you own.
Capital Gains: The money you make from selling a stock (or other asset) for more than you bought it for. For example, if you buy 10 shares at $5 (which equals $50) and they go up in value to $10 (which is a total of $100) and you sell, then you’ve made $50 in capital gains ($100 total minus the original $50 equals $50 in capital gains). Tax rates are quite high for capital gains.
Return on Investment (ROI): How much money you get back, usually measured yearly, on the money you invest in something. For example, if you invest $1,000 and receive $100 back from that in the course of a year then you’ve had a 10% return on investment.
Index Fund: A way to invest in stocks that puts a little bit of your money into every company listed in that index or list of companies. For example, the index could invest in all companies in the S&P 500 or all publicly traded companies, etc.