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What Is a Prospectus and How Do You Read One?

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ProspectusInvesting in stocks, mutual funds and other securities inevitably comes with risk. One of the ways investors can better understand these risks is by reading the prospectus of a security. A prospectus is a legal document that describes a security to potential investors. Required by the SEC, a prospectus contains facts about the company or fund issuing the security, including details on its finances, management, history and other information that could help investors make an informed decision. The prospectus is a key tool in an investor’s toolbox, making it easier to understand whether or not you’re investing in a way that aligns with your goals and risk tolerance.

What Is a Prospectus?

A prospectus is a legal document that a company or mutual fund must produce when it is offering a security for sale. The prospectus provides detailed information about the security so that potential investors can better understand what they’d be buying. Among other things, this information can include:

  • Background on the company and its current financial situation
  • How many total shares are being issued
  • The type of security being issued (stock, bond, fund, etc.)
  • The name of the institution underwriting the offering, if there is one
  • Information about dividends

This information is meant to notify potential investors that the security is either coming or is currently available. In addition, a prospectus can help investors determine whether the security might be a fit for them.

A prospectus typically comes in two different forms: preliminary prospectuses and final prospectuses. When a company or fund is preparing to release a new security, it will issue a preliminary prospectus. Then, once the offering is complete and actually available to investors, a final prospectus will also be available. The two versions will likely have many similarities, with the final prospectus containing more details and any changes that took place during the finalization process.

How to Read a Prospectus

Prospectus

The purpose of a prospectus is to evaluate if an investment is right for your goals, risk tolerance and existing investment portfolio. You may not need to closely read every word in the prospectus to come to this decision. In fact, it’s unlikely you will. Instead, the best approach is to read through the document with an eye for several crucial pieces of information.

The first objective when reading a prospectus is to develop an understanding of the company’s business model and goals, if it is indeed a company issuing the prospectus. Once you’ve accomplished that, you’ll want to carefully consider the risk factors the prospectus lays out. Be sure to reflect on if the prospectus is portraying an investment that aligns with your personal risk tolerance.

Finally, most prospectuses will include information about what the proceeds of the security’s performance will be put toward. Consider if these align with the company’s business model and if they’ll generate consistent value.

Once you feel confident in your understanding of the prospectus, it may be worth checking to see if there’s any overlap between the security or fund in question and the investments in your current portfolio. By doing this, you can identify whether or not your portfolio will lose diversification value if you decide to invest in the new security or fund.

Mutual Fund Prospectuses

A mutual fund prospectus details the strategies and objectives of a specific mutual fund. This information will differ slightly from a stock prospectus, as it will include the fund’s past performance, as well as the managers of the fund and their history. Both types of prospectuses, however, will discuss the issuer’s plans and objectives. This will allow you, the investor, to determine if it would be a good fit for your portfolio.

A mutual fund prospectus will also likely include a discussion of the fund’s investment strategy, something that isn’t applicable to a stock. This could include information about asset allocation targets or any restrictions the fund may place on its investments.

By law, every mutual fund prospectus must include information regarding the risks involved in investing in the fund. In this section, the fund will illustrate the nature of the risk you’ll assume by investing, both the magnitude and the provenance of that risk. While risk is inherent in investing, not all funds will align with your personal risk tolerance. Knowing this, you’ll want to examine this section closely before making a final investment decision.

Sometimes mutual fund prospectuses may go by different names than the ones listed above. The first of these is a summary prospectus, which gives only a short overview of the fund, its strategy and goals. The second, a statutory prospectus, is much longer and more comprehensive.

If you’re looking to find the prospectus of a particular fund, you can usually get your hands on it by heading to its website or reaching out to the fund via email or phone.

Bottom Line

Prospectus

A prospectus is a crucial piece of information for the potential investors of a stock or other security. It helps them understand any potential risks that could come with the purchase of the security, among other things. Without a prospectus, investors would have little to no information to help them make their decision.

Tips for Getting Into Investing
  • If you don’t feel qualified to perform your own investment research, consider working with a financial advisor who can do the work for you, assembling and managing a portfolio that fits your needs. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Asset allocation is crucial for investors when it comes to managing risk in their portfolios. A prospectus can help you determine the asset classes of a security and whether its risk level makes sense for your portfolio. SmartAsset’s asset allocation calculator can help you find the allocation most appropriate for your financial goals and risk tolerance.

Photo Credit: iStock.com/utah778, iStock.com/nortonrsx, iStock.com/skynesher

The post What Is a Prospectus and How Do You Read One? appeared first on SmartAsset Blog.

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