If you are like most people you probably do not invest in many individual stocks. Corporate stock investors devote a lot of time to researching companies, their revenues, and the growth or declines of their industries. The average investor just cannot do that. So that leaves most of us with the option of investing in mutual funds.
When you buy into a mutual fund your shares represent your portion of the value of the fund itself, which is estimated on the basis of its cash on hand and the market value of the stocks and/or other securities it holds.
Some mutual funds are built to almost run on autopilot. These are the so-called “index funds” and what they do is maintain a balance in their holdings that approximately equal the theoretical value of the stocks listed in a specific index. The most famous index is the Standard and Poor 500 and when investment counselors talk about investing in an index fund they usually recommend a fund that is based on the S&P 500.
Some mutual funds are built to accrue value by way of dividends and interest payments. These income-producing funds are considered to be safer than most mutual funds because the fund managers only invest in companies that tend to do well in the current economic climate. The funds declare the types of stocks (or bonds) they will invest in and the fund managers buy into or sell out of companies within that narrow field.
A dividend fund will produce very steady income in most quarters unless the economy is doing very badly, especially if the fund tracks companies in multiple industries. An index fund may not produce steady income, especially if the economy worsens.
Index funds are expected to increase in value over long periods of time because the companies they invest in tend to be stable and to recover from economic downturns in good time. You make more money from an index fund by selling your shares in it than by collecting dividends and interest.
The idea is to buy shares continually over many years. Those early shares will eventually become worth much more than you paid for them. For example, you may buy shares in an index fund at $10 each and in ten years sell them at $20 each. You realize a profit of $20 per share. And, of course, some of those shares may have received dividend payments.
Sometimes a mutual fund will “split” its shares. This is done to reduce the “Net Asset Value” of the fund’s shares, to cut the price as it were, so that buying into the fund is less expensive for new investors. If you hold $100,000 in a mutual fund across 10,000 shares and the fund splits its shares, you will end up with 20,000 or 30,000 shares but the total value of your shares will remain $100,000.
The mutual fund splits its shares so that you can buy more at a lower price. In this way more investors may pick up shares in the fund and the fund can use their money to make some new investments. Over time the price of the shares should increase again.
When a mutual fund’s share prices are adjusted downward without a split that means you have lost Net Asset Value (NAV). The value of your holdings has declined. This is an undesirable situation unless the mutual fund pays dividends based on the dividends it receives from stocks or based on the profit it makes by selling its stocks.
Dividend funds are considered a better option for people who retire and live on a fixed income. But if you have $2,000,000 invested in an S&P 500 index fund you may be okay. You’ll only have to sell off a small percentage of your shares each year and the money you do not use can be put into bonds or a dividend fund. This way the value of your wealth continues to grow without depriving you of income.
You could also try converting your index fund holdings to dividend fund holdings on a gradual basis, perhaps reducing your index fund investment by 10% every year. It may take more than 10 years to fully sell off your index fund holdings.