The rate of an investment is a metric used to measure how much the investment returns after a certain amount of time. For example, suppose a bank customer puts $1000 into a certificate of deposit (CD) account that is advertised at a rate of 5% per year. The bank customer should expect that at after a year he would get back $1050, which is 5%. Of course, the return on investment does not always mature exactly after one year, but instead is updated constantly such that at the end of the year it is at 5%.
But not all financial instruments have rates like CDs and savings accounts. The ones that do are exemplified by government bonds, bank accounts (and the CDs discussed above). The rest of the universe of financial instruments such as securities, stocks, and high yield mutual funds do not have rates. An investor who puts money into a share of stock should expect the return of a fixed sum. Again, a hypothetical investor puts $100 into buying some shares of a company. After a year period, those shares can be anywhere in value (within reason), such that the investor may have even lost money.
Stock market mutual funds are very much like the individual stocks. Because a mutual fund is just made up of many stocks, its value should also show variations except now the variations are averaged out over its many component stocks. This ensures that the mutual is not strongly affected by a drop in any single underlying security, but does not ensure that the mutual fund never experiences a decline in value. The question many first-time investors ask is what the advertised “mutual fund rates” really mean. This is important as companies offer high yield mutual funds as investments yet the definition of high yield mutual fund is not apparent.
The rate in question is what one sees when reading over the fund information in the offering financial institution. For example, suppose Vanguard or Fidelity offers a particular index fund. A prospective investor will often read that the rate of return for the fund was 15% for 2007, 10% for 2008, and 8% for 2009. The truth is that these rates are not true rates, but rather “historical rates of return” for the index fund. That means it is merely what the index fund returned for those years, and is not guaranteed for the future.
The source of fluctuations for mutual funds from year to year is derived from two reasons. One is that the underlying securities or the component securities of a mutual fund go up and down all the time depending on the fortunes of a company, the activity of the sector to which the company belongs, or to general condition of the economy as a whole. Another is that the companies included in the mutual fund sometimes pay dividends to its shareholders. In this way mutual funds can gain value even though the stock is lackluster.
The key point to remember is that rates, for example of stock, bond and GNMA mutual funds, are only historical rates, and are not the same as rates for fixed income securities like savings accounts, bonds and certificates of deposit. High yield mutual funds should also be interpreted in this light.
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