How to invest in mutual funds
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- A mutual fund pools money from investors to purchase multiple securities.
- Mutual funds are typically actively managed, but there are passive mutual funds like index funds.
- When you invest in mutual funds, be aware of fees.
A mutual fund is a type of investment vehicle that pools money from many investors to purchase stocks, bonds, or other securities. Investors who mutually contribute to the fund company become part owners of the fund’s portfolio and the investment gains or losses it generates.
You can invest in mutual funds through one of the best brokerage accounts. Here’s what you need to know about mutual funds, including how they work, what to watch out for, and how to get started investing in them.
Understanding mutual funds
Mutual funds provide broad access to a diversified pool of investments for relatively small upfront amounts and can offer investors access to professional investment management.
What are mutual funds?
According to the Securities and Exchange Commission (SEC), a mutual fund is an open-end investment company registered with the SEC that pools money from various investors into asset classes like stocks, bonds, and more.
“Mutual funds are an easy and well-established way to give everyday investors diversification,” says Michael Iachini, CFP and head of manager research for Charles Schwab Investment Advisory. “They are well established since the 1920s and have a track record of working for investors.”
Unlike shares of stock, you can purchase shares of a mutual fund directly through the fund provider. Buying one of these shares gives you partial ownership of the fund’s total portfolio.
Many investors use these funds. According to Statista data, more than $25.5 trillion was invested in mutual funds as of 2023. That same year, 52.3% of US households were invested in these funds, according to figures from the Investment Company Institute.
How mutual funds work
The main components of how mutual funds work include the following:
- Pool money: Mutual funds pool investors’ money to buy securities like stocks or bonds, depending on the mutual fund’s investment strategy. Most mutual funds are open-ended, meaning that shares of the fund can continually be created or destroyed, depending on whether investors are putting money in or pulling money out.
- Professional management: Generally, mutual funds are professionally managed, either by an individual portfolio manager or a team of investment professionals, who set the fund’s investment strategy and manage the buying and selling of securities.
- Net asset value (NAV): The price of a mutual fund is determined by its net asset value (NAV), which considers all of the portfolio’s securities. It is found by dividing the total value of the fund’s assets (cash and securities) by the number of outstanding shares of the fund.
Types of mutual funds
There are multiple types of mutual funds to invest in, such as:
Stock funds
Stock funds invest in shares of companies. There are some nuances within stock funds, including those that focus on investing in growth-focused stocks.
“Mutual funds are baskets of various stocks with a common theme behind them,” says Gary Grewal, a CFP. “They usually have a net asset value, which is determined once per day, unlike stock prices that fluctuate during the day in the markets.”
Bond funds
Bond funds are a type of basket of securities that invest in a mix of bonds and debt securities. The risk related to bonds can differ depending on the bond.
Money market funds
Money market funds are fixed-income mutual funds that invest in short-term debt securities with low credit risk. These funds aim to provide liquidity, maintain a stable NAV, and distribute regular income earned on its securities to its investors.
Depending on the securities held within them, money market funds are categorized as government, prime, or tax-exempt.
Target-date funds
Target-date funds contain a combination of stocks and bonds that aim to help you retire by a certain date. They can also be referred to as lifecycle funds. These funds will shift their allocation between different assets over time to achieve their overall goal.
Equity funds
Equity funds invest mostly in stocks and are often categorized by factors like investment style and market capitalization. For example, a large-cap growth equity fund invests in large companies that are expected to have above-average growth in revenue and profit.
“Remember there are more than 10,000 equity mutual funds, yet there are only 2,800 stocks that trade on the New York Stock Exchange,” says Clark Kendall, president and CEO of Kendall Capital. “Equity mutual funds do a great job of slicing and dicing the equity markets however you would like to have your market served to you.”
Growth funds
Equity funds are often divided by investment style, with growth funds typically applying to mutual funds that invest in growth stocks. Growth funds generally aim to beat the market through capital/price appreciation, as opposed to receiving significant dividend income.
Value funds
In contrast to growth funds, value funds invest in stocks that are considered to be undervalued based on underlying financial fundamentals. Value stocks are often well-established companies that pay dividends. However, just because some investors consider them undervalued does not mean they will outperform the market.
Blend funds
Blend funds combine different investment strategies, like investing in a mix of growth and value stocks or large-cap and small-cap companies.
Benefits of mutual funds
Mutual funds can provide investors with quick exposure to a diversified portfolio of assets.
Let’s further break down the advantages of mutual funds:
- Diversification: You can access a broad base of underlying investments through one investment. This can help reduce risk and volatility, often leading to better returns than non-diversified investments.
- Management: You get the benefit of the professional manager trying to match the fund for you rather than you having to replicate the fund by trading individual stocks.
- Liquidity: Although mutual funds aren’t quite as liquid as other investments like ETFs, buying and selling shares is generally easy and fast.
- Convenience: Not only does the fund manager handle the investment strategy for you, but mutual funds also often stand out from ETFs in terms of convenience, such as by making it easy to set up automatic investment plans to purchase fractional shares.
Disadvantages of mutual funds
Although mutual funds offer a lot of possible advantages, there are some downsides to watch out for, such as:
- Fees and expenses: Mutual funds carry annual fees, known as expense ratios, that can eat into returns. These are expressed as a percentage. For example, a 1% expense ratio means you pay 1% of the invested amount in fees per year. That might not sound like much at first, but it adds up over time.
- Investment minimums: Many mutual funds have investment minimums, and while these are often still accessible for individuals, the minimums can be several thousands of dollars.
- Lack of control: The flip side of professional management is that you lack control over the underlying investments. You can choose the fund you’d like, but you don’t get to decide when the manager buys or sells securities, and the fund might invest in companies you don’t want to own.
- Tax inefficiency: Mutual funds can trigger capital gains taxes based on the gains and losses of the fund overall, not just your own investments.
Steps to invest in mutual funds
Here are the steps you need to take to add mutual funds to your diversified portfolio.
Step 1: Determine your goals and risk tolerance
Before you invest in mutual funds, it’s important to review your current income, expenses, monthly debt obligations, and net worth to assess your financial situation. Knowing your finances can help you determine how much you can afford to invest and what your asset allocation should be based on your risk tolerance.
In addition, consider your short and long-term goals when investing. Knowing your goals and having a rough timeline can ensure that you stay on track and understand why you’re investing in the first place.
Step 2: Research and choose your funds
There are many different types of mutual funds that you can invest in. They all come with unique characteristics, and being familiar with these features can help you to know what to look for when choosing mutual funds.
Mutual funds are managed in one of two ways:
- Passive management: Passively managed mutual funds, such as index funds, seek to replicate market returns of a particular index, such as the ever-popular S&P 500. They are more affordable for investors since no fees go toward paying for a management team.
- Active management: Actively managed mutual funds use their management team to try to beat the market. “Active funds typically come with higher expense ratios and may even come with a sales charge. Active means there are human portfolio managers whose job is to manage the investments within the mutual fund to try and beat the market,” Grewal says.
You should also consider the expense ratio, which includes costs related to managing your account for both active and passive mutual funds.
Step 3: Open an account (brokerage or directly with a fund company)
Before you purchase shares of a mutual fund, you must have the appropriate account. Fortunately, there are many different ways you can buy mutual fund shares.
“One can easily invest in mutual funds via their workplace retirement plan, IRA, or opening a brokerage account through Fidelity, Schwab, and Vanguard,” says Grewal.
Most investors use brokerage accounts to buy mutual fund shares. You can check out some popular options, such as Fidelity, Vanguard, and Charles Schwab. Before opening an account, be sure to review the prospectus and any fine print, and also consider the following:
- Any account minimums required
- Usability of website and mobile app options
- Available funds
- Total costs such as sales load and expense ratio
Step 4: Purchase your fund shares
The amount you pay will vary based on the sales charge or sales load and the fund’s net asset value per share. You may also be able to invest in mutual funds that don’t have a sales load associated with them. Develop a plan to add funds regularly, such as each month, and review your performance as you go to see if any changes should be made.
Step 5: Monitor and rebalance (if needed)
Evaluating your mutual fund performance monthly, quarterly, or annually might be far more effective than watching their value change daily. For many investors, the most effective method is rebalancing one’s portfolio annually. This approach can result in fewer transaction fees than rebalancing more frequently.
Rebalancing is restoring one’s portfolio to its original target allocation. For example, an investor may want an allocation of 60% stocks and 40% bonds, which could be achieved by allocating 60% stock mutual funds that invest in stocks and 40% bond mutual funds.
FAQs about mutual funds
You can buy mutual funds through brokerages or investment platforms, and you may be able to access these funds through workplace retirement plans like your 401(k). Some mutual funds can be purchased directly from the fund manager, like through a Fidelity or Vanguard account, or you might buy funds through a third-party brokerage.
Investing in mutual funds has a few tax implications. Mutual funds can trigger capital gains taxes based on the gains of the fund itself, not just your own trading. Also, mutual funds can generate dividends, which are often taxed as ordinary income. However, holding mutual funds in a tax-advantaged account like a 401(k) can minimize these tax implications.
Mutual fund prices, known as NAVs, are updated once per business day after the market closes, based on price changes for the underlying assets.