How do investment funds work?

They all work on the same broad principles:

  1. Investors buy shares in a fund

  2. Their money is pooled together

  3. The fund uses its pooled capital to invest in specific assets

  4. Investors are rewarded based on the fund's overall performance

What is the difference between the funds?

  1. 1.

    Income funds: Pay any profits to your nominated bank account. This means that you can withdraw the money as an alternative income.

  2. 2.

    Accumulation funds: Are designed to generate growth rather than income. Your profits are automatically reinvested to buy more shares in the fund. Your stake in the fund grows, as should your profits if the fund performs well.

Most funds let you choose between income and accumulation, so you can decide if the investment is totally geared to the future, or if you benefit from any income now.

Which fund is safer?

All investments involve some risk: profit cannot be guaranteed and the value of the fund can fluctuate.

The risk is relatively equal as the safety of your money mostly depends on what the fund invests in:

  • Stocks and shares are generally thought to have greater inherent risk, but even this can be reduced by investing in a spread of businesses and markets.

  • Securities, gilts and corporate bonds are typically thought to be the safest options and will often pay a fixed return.

Both funds limit your risk by pooling your money with other investors'. This increases their purchasing power so the fund can invest in a wider range of assets. Think of it as having fewer eggs in one basket.

Income funds are slightly safer as each withdrawal reduces your exposure. However, withdrawing the earnings will limit the growth of your overall investment.

Which fund should you choose?

If you need a regular income from your investments then an income fund lets you marry short term benefits of a regular income with some aspects of a longer term investment (the fund's own shares or unit price).

On the other hand:

  1. 1.

    If fund performs well: Reinvesting your earnings through an accumulation fund means your holding will grow faster, alongside the potential of profit.

  2. 2.

    If it performs badly: Even more of your money is invested and is subject to stock market risks.

When it comes to deciding whether income or accumulation is the better choice for you, weigh up your short term and longer term needs.

After that you will need to compare investment funds and choose those with underlying investments that match both your goals and your attitude to risk.