Mutual Funds — What They Are and How They Help You Profit

You’ve probably heard the saying “don’t put all your eggs in one basket.” Well, that’s the mindset behind investing in mutual funds, a very popular option among those with little experience in the field who want a simple and accessible way to make their money work for them.

In this article, we’ll define mutual funds and understand how they work, identify criteria for choosing the right mutual fund for you, look at popular investment strategies, and review the most important ways you can keep risks to a minimum.

Let’s get started!

What Are Mutual Funds and How Do They Work?

Before we get into more complicated things, it’s essential to understand what mutual funds are and how they work.

Definition and Structure of a Mutual Fund

Simply put, a mutual fund is a type of collective investment that pools money from many investors to invest in stocks, bonds, government securities, or other financial assets.

These funds are managed by professionals who are skilled in market analysis and invest the pooled capital in various financial instruments. From these investments, each investor benefits from a share of the profits.

Mutual funds are advantageous for those with little experience because they provide access to an investment portfolio that they could not otherwise build on their own. Instead of risking their capital on their own and investing in a single stock, they choose to invest in a mutual fund and spread their investments across multiple markets.

The structure of a mutual fund involves a common fund managed by an investment management company, also known as an Asset Management Company (AMC). Each investor owns fund units — the equivalent of stock shares — and their value fluctuates based on the performance of the assets in the portfolio.

Role of Asset Management Companies (AMCs)

Mutual funds are managed by AMCs, whose role is to select and manage the investments in a portfolio, make decisions regarding dividend distribution, and monitor the fund’s performance, in exchange for a management fee.

These entities are regulated by financial authorities and are responsible for the proper management of mutual funds.

In addition, AMCs can provide investors with periodic information regarding the evolution of the funds and associated risks.

Main Types of Mutual Funds in Romania

In Romania, we encounter several types of mutual funds that differ either by investment strategies, the risks involved, or the financial objectives they pursue.

Among the most popular mutual funds in Romania are:

• Equity Funds — invest in the stocks of companies listed on capital markets and are considered riskier, although they offer high returns over the long term.
• Bond Funds — invest in government securities or bonds issued by companies and are safer than equity funds but offer lower returns.
• Balanced Funds — combine investments in stocks and bonds and offer risk diversification, helping investors achieve moderate returns.
• Money Market Funds — invest in short-term financial instruments, such as bank deposits or government securities, have low risk, but also lower returns.

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How to Choose the Right Mutual Fund for You

Now that you understand what mutual funds are and how you can make money with them, it’s important to know the steps you need to take before investing your money in such a fund.

Evaluating Your Risk Profile

Before investing in a mutual fund, it is essential to establish the level of risk you are willing to take in these investments. This process is known as risk profile evaluation.

If you want high returns and are willing to take more risk, equity funds or balanced funds might be the right choice for you. On the other hand, if you prefer to limit your risk, you might give bond funds or money market funds a chance.

Analyzing Your Financial Goals

Next, it’s important to establish your financial goals. Before investing, think about exactly why you are doing it. You can invest to save for a vacation, your children’s education, or even for retirement.

Each financial goal has its own specifics. For some, you have more time to achieve returns and can deal with greater market fluctuations; for others, you need stable forms of investment that protect your capital and offer short-term returns.

Comparing Fees Among Mutual Funds

Finally, pay attention to expenses. All those fees or management charges are deducted from the profits you make.

So, before you choose a mutual fund, it’s important to compare these costs and make sure they are reasonable relative to the returns the fund offers. This will help you maximize your profit.

Investment Strategies in Mutual Funds

Depending on your financial goals, you can adopt one or more investment strategies in mutual funds. Here are some of the most popular.

Lump Sum vs. Systematic Investment

Two of the most important investment strategies in mutual funds are lump sum investment and systematic investment.

Lump sum investment involves placing a large amount of money at once, while systematic investment involves consistently — daily, monthly, or weekly — placing smaller amounts of money.

If you opt for systematic investment, you can benefit from lower prices when the fund unit value drops and from higher prices when their value increases. This strategy is called dollar-cost averaging and helps reduce the risk of investing at the wrong time.

Portfolio Diversification Across Funds

Diversification is a key word when it comes to risk management and protecting your earnings. Think about it: the more varied your investments, the more the risks are spread across different companies and sectors.

Losses in one sector or asset can be offset by gains in other sectors, making your investment more stable and less exposed to market fluctuations.

Risk Management in Mutual Funds

No form of investment is without risks. Therefore, before you put your money into such a fund, it’s important to know what the risks are and how you can keep them under control.

Specific Risks of Mutual Funds

Even though mutual funds are a safer option than other forms of direct investment, they are not without risks.

The most important risks characteristic of mutual funds are:

Volatility Risk

Normally, equity-based funds invest in publicly traded company shares. Their value depends on how the company performs, which can be affected by a myriad of microeconomic factors.

Credit Risk

Occurs when the issuer is unable to pay its debts — whether interest or other charges.

Liquidity Risk

Can be defined as the ease with which a security can be sold at its true value or close to it, depending on market trading volumes.

Management Risk

Occurs when the fund’s performance also depends on the competency of the AMC managing it.

Inflation Risk

Can be described as the risk that arises when, due to inflation, purchasing power decreases. Normally, investors are exposed to such a risk when the ROI they obtain does not keep pace with the inflation rate.

Concentration Risk

Occurs when investors concentrate all their money in one investment scheme or a single sector.

Techniques for Minimizing Risks

To reduce the impact of risks you might face when investing in mutual funds, make sure that you build a portfolio that matches the level of risk you are willing to assume. It’s essential to invest only in mutual funds that align with your risk tolerance. You diversify your portfolio and allocate investments across multiple asset classes and sectors to balance the risk-reward ratio of your portfolio.

Monitoring Investment Performance

After you’ve made the decision and invested, your job isn’t over. It’s essential to keep an eye on it and monitor its performance to ensure it aligns with your financial goals. Depending on these, as well as how the market evolves, you may need to periodically adjust your portfolio.

Most platforms provide periodic reports where you can see how well your investments are performing.

Important Tax and Legal Aspects

Finally, it’s important to know the legislative framework in which mutual fund investments operate. This includes both the taxes you need to cover and how you are legally protected in critical situations.

Taxation of Gains from Mutual Funds

In Romania, you need to pay an income tax on the gains you make from mutual funds, which is deducted from the profit you have made. Most often, this tax is withheld directly by the AMC, so you don’t need to worry about paying it yourself.

Even so, it’s important to stay informed and know the tax regulations that apply to the forms of investment you’ve chosen, to understand how the gains from funds are taxed.

Legal Framework and Investor Protection

The Financial Supervisory Authority (ASF) plays an important role in regulating and monitoring mutual funds in Romania. It sets strict rules to protect investors and ensures that mutual funds adhere to standards of transparency and risk management. In addition, mutual funds are required to provide detailed information about risks, fees, and historical performances. All these details help investors make informed decisions.

Moreover, most mutual funds are protected by various guarantee schemes that secure investors in case of a financial institution’s insolvency.

As you can see, mutual funds are an accessible investment option that might suit you if you don’t have much experience in this field but aren’t satisfied with just a simple savings account. However, even though these funds are managed by experienced, qualified people, which maximizes your chances of success, don’t relax completely! It’s essential to ensure you are well-informed, know your objectives, and are aware of the existing risks. No form of investment is without risks, so it’s good to know all the details from the beginning and choose the best options for yourself.

To build your wealth over the long term, it’s important to be disciplined, patient, and stay informed throughout the process.