How to Invest in Mutual Funds

Mutual funds have long been a popular choice for first-time investors, and for good reason. These investment vehicles offer a simple, accessible, and diversified way to enter the investing world, making them a good option for many Americans.

Given the many changes in the U.S. economy in recent decades, including the steep drop in the number of Americans with defined pension plans, mutual funds are frequently the vehicle of choice for long-term investing, with a majority—52%—of American households with money in them as of 2022, a vast increase from the 5.7% in 1980. They are now the backbone of middle America’s retirement savings.

Mutual funds pool money from many investors to purchase a diversified portfolio of securities, such as stocks and bonds. Established by 1940 legislation, these funds are meant to be relatively lower in risk. They were to pool the investment capital of many Americans and provide access to a broader range of assets and the safeguards of professional money management that otherwise would have been too costly to obtain on their own.

A significant benefit of investing in mutual funds is diversification. By spreading your investment across a variety of securities, sectors, and locations, you reduce your portfolio’s overall risk. The performance of different investments is often different even in the same market conditions, so gains in another can offset losses in one.

Mutual funds also cater to various investment goals and risk tolerances. There are over 9,000 mutual funds to choose from in the U.S. alone. Each has its own investment strategy and goals. Whether you’re looking for aggressive growth, steady income, or a balanced approach, there is likely a mutual fund that aligns with your needs.

But how can you add mutual funds to your portfolios? Putting your money into mutual funds is done differently from trading stocks. Unlike stocks, which are traded throughout the day on stock exchanges, mutual fund shares are purchased and sold directly through the mutual fund company or a brokerage firm. Fund shares are priced once at the close of each trading day. Many people set money aside in mutual funds through their paychecks, some with matching funds from their employer.

But don’t let this overwhelm you. Owning mutual funds is easier than it sounds. Just read on to find out how.

Type of Mutual Funds

Understanding the different types of mutual funds can help you find the one that best aligns with your financial goals and risk tolerance.

Here are some of the main types:

Equity Funds

Also known as stock funds, equity funds live up to their name by investing in publicly traded companies. Their goal is to increase the value of your investment by putting money into companies expected to grow.

An essential factor to consider when evaluating equity funds is market capitalization, which refers to the total value of a company’s outstanding shares. Generally, larger companies tend to be more stable and less risky, while smaller companies may offer higher growth potential but also have increased risk. They may be the next big thing or soon forgotten.

Equity funds can be broken down by looking at these factors:

• Market capitalization: Large-cap funds invest in companies with a market value exceeding $10 billion, which are ordinarily more established and less volatile. Midcap funds focus on companies worth $2 billion to $10 billion, offering a balance between growth and stability. Small-cap funds invest in companies with a market value below $2 billion, which may have higher growth potential and risk.
• Investment style: Growth funds invest in companies with high growth potential, prioritizing capital appreciation over income through dividends. Value funds seek undervalued stocks believed to be trading below their true worth, aiming to benefit from a potential price increase. Blend funds provide a more balanced approach between the two.
• Geography: Domestic funds focus on stocks of U.S. companies, while international funds invest in stocks outside the U.S. Some funds may also focus on a specific region, such as Europe or Asia. International funds can offer diversification benefits but may also be subject to additional risks, such as currency fluctuations and political instability.

Bond Funds

Bond funds invest primarily in fixed-income securities, such as corporate, government, and municipal bonds. They aim to provide regular income and add stability to a portfolio. Bond funds can be categorized based on the type of issuer or bonds in which they invest (e.g., government vs. corporate), the credit quality of the issuers (from investment-grade to junk), and the duration of the bonds (from short-term to long-term).

Balanced Funds

Also known as hybrid funds, balanced funds invest in a mix of stocks and bonds to offer a balance of growth and income. The allocation between stocks and bonds depends on the fund’s investment strategy and risk profile, but the most common is 60% in stocks and 40% in bonds. These funds are suitable for investors seeking a single, diversified investment solution.

Money Market Funds

Money market funds invest in short-term, low-risk debt securities, such as Treasury bills, certificates of deposit (CDs), and commercial paper. They aim to maintain a stable value and provide a low-risk, liquid investment option. Money market funds are often used for short-term savings or as a temporary holding place for cash. They are more attractive when interest rates are high since they earn more interest.

Index Funds

Index funds and target-date funds are the most popular. Index funds passively track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. If that index performs well, so does the fund.

Target-Date Funds

Target-date funds, also known as life cycle funds, are designed for investors with a specific retirement date in mind. Over 85% of 401(k) plans offer these funds, which automatically adjust their asset allocation over time, becoming more conservative as the target date approaches. This “set it and forget it” approach is great for investors who want a simple, long-term investment solution.

Specialty Funds

Specialty funds focus on specific investment strategies or asset classes beyond stocks and bonds. Here are some examples:

• Sector funds invest in companies within a particular industry or sector, such as healthcare, energy, or technology.
• Socially responsible investment (SRI) funds, also known as environmental, social, and governance (ESG) funds, invest in companies that meet specific social, environmental, or ethical criteria.
• Real estate funds invest in real estate investment trusts or buy their own real estate holdings.
• Commodity funds invest in physical commodities like gold, oil, agricultural products, or commodity-linked derivatives.

How to Invest in Mutual Funds, Step by Step

1. Set Your Investment Goals and Budget

As with any investment, it’s important to set clear goals that align with your broader financial objectives, time horizon, and risk tolerance before investing in mutual funds. Determining your investment goals and budget is crucial before investing in mutual funds. Consider the following factors:

• Investment objectives: Identify your reasons for investing, such as saving for retirement, buying a home, funding your child’s education, or building wealth over the long term.
• Time horizon: Determine how long you plan to invest before you need to access your funds. This will help you choose the mutual fund that matches your timeline.
• Risk tolerance: Assess your willingness to take on financial risk. Some investors are comfortable with the potential for higher returns despite increased volatility, while others prefer a more conservative approach.
• Financial situation: Assess your current income, expenses, and debts to determine how much you can realistically afford to invest without compromising your financial stability.

You can sort these out by answering a few questions:

1. What are my primary financial goals, and how can mutual funds help me achieve them?
2. How long do I plan to invest in this fund, and am I comfortable with the potential market ups and downs during that time?
3. Am I willing to accept more risk for potentially higher returns, or do I prefer a more stable investment approach?
4. How much can I afford to invest in mutual funds, and how often (e.g., one-time lump sum, or monthly contributions, or something else)?
5. What types of mutual funds best align with my goals and risk tolerance (e.g., equity, bond, and balanced funds)?
6. Do I prefer actively managed funds with higher fees or passively managed funds with lower costs?

2. Narrow Down Your Choices

There are many, many mutual funds—more than 9,000—from scores of providers. With your goals and budget in mind, begin researching the mutual funds that match your answers to the above questions.

If you choose your retirement plan through your employer, you might be given a catalog (virtual or a glossy version) detailing different funds offered there. However, these can be out of date—even a few months can matter—and produced by the management companies pitching you to join them. Even if they are scrupulous and have fair judgments about their own products, it’s best to see what outsiders think, too.

Use your brokerage platform or reputable financial websites like Morningstar or Yahoo! Finance to compare funds and read expert analyses. You can also find helpful tools like mutual fund “screeners,” where you put what kind of fund you are looking for, and the results are narrowed down for you.

As you choose a mutual fund, these items can act as your 10-point checklist. It looks like more work than it is—most details are found in the same places online:

1. Fund type: Choose funds that match your investment objectives, such as growth, income, or a combination of both.
2. Investment style: Consider whether you prefer actively managed funds that attempt to outperform the market or passively managed index funds that track market performance.
3. Expense ratios: Look for funds with low expense ratios, as high annual management costs can eat into your returns over time. Try to find the least expensive funds for your fund type and style, but don’t choose based on fees alone.
4. Loads: Be aware of any extra fees with mutual funds. Some funds carry sales charges, known as loads, that can eat into your investment returns. Front-end loads are charged when you first buy shares in the fund, while back-end loads are charged when you sell shares.
5. Additional fees: Look for no-load funds to avoid these charges. Additionally, pay attention to other fees, such as redemption fees and 12b-1 fees, which are for marketing and distribution. These fees vary significantly among funds, so comparing them carefully and understanding their influence on your returns is essential.
6. Minimum investment: While some mutual funds do not have a minimum investment to start investing, some do. The upfront investment could be $100, $1,000, or more. These tend to be waived if you choose a fund through your employer.
7. Fund manager experience: To assess the fund manager’s track record, visit the mutual fund company’s website or review the fund’s prospectus. Look for the manager’s biography, including their investment philosophy, educational background, and previous experience managing funds. A manager who has been with the fund for several years, ideally five or more, may indicate a more stable management approach.
8. Fund size: The fund’s assets under management (AUM) can be found in the fund’s fact sheet or prospectus. A larger AUM, typically $100 million or more, suggests that the fund is well-established and has enough to manage the fund effectively.
9. Liquidity: This refers to how easily the fund can convert its investments into cash to meet redemption requests. Funds with higher liquidity can accommodate investors coming into and out of the fund. A good indication of liquidity is if the fund invests primarily in large-cap stocks or high-quality bonds that can be bought and sold quickly without significantly impacting the fund’s performance.
10. Tax implications: If investing in a taxable account, consider tax-efficient funds that minimize turnover and distribute fewer capital gains.

Remember, there is no one-size-fits-all approach to selecting mutual funds. Your circumstances and goals should guide your investment decisions.

3. Select the Right Mutual Fund for You

Next, examine the fund’s prospectus, which provides detailed information about the fund’s investment objectives, strategies, risks, and fees. Pay close attention to the fund sponsor’s reputation, the managers’ profiles, and the fund’s historical performance—but keep in mind that past performance doesn’t guarantee future results.

After thoroughly researching potential mutual funds, select those that best align with your investment goals and risk tolerance while minimizing costs. Diversification is key to managing risk, so consider spreading your investments across various fund types, sectors, and locations. Asset allocation, or the distribution of your investments among stocks, bonds, real estate, cash, and other assets, is crucial in building a well-balanced portfolio.

4. Open an Investment Account

If you’re not acting through your employer, you’ll need to open an investment account with a brokerage firm or directly with a mutual fund company to invest in mutual funds. If you don’t already have one, here are a few types of investment accounts that you may be able to choose from:

• Taxable brokerage accounts: These accounts allow you to invest in a wide range of securities, including mutual funds, stocks, and bonds. They can be held as an individual, as a joint account with a spouse or partner, or as a custodial account held on behalf of minor dependents.
• Retirement accounts: 401(k) plans and individual retirement accounts (IRAs) offer tax advantages and are designed for long-term investing. Roth IRAs are a tax-exempt retirement account option where you can put dividend-paying mutual funds without triggering taxable events.
• Education savings accounts: Accounts like 529 plans can help you save for future education expenses.

When opening a new account, you will provide personal information such as your name, address, Social Security number, and employment details. You will also need to fund your account by transferring money from your bank account or mailing a check.

5. Place Orders and Make Contributions

Once your investment account is set up and funded, you can start investing in mutual funds. You can invest a lump sum or make regular contributions over time—perhaps right out of your paycheck. Lump-sum investing involves investing a significant amount of money at once, which can be advantageous if you believe the market will rise. However, this approach also exposes you to greater market risk.

Another strategy is dollar-cost averaging, which involves investing a fixed amount of money at regular intervals, regardless of market conditions. This approach can help mitigate the impact of market volatility on your investments, as you buy more shares when prices are low and fewer shares when prices are high.

To place an order, log into your investment account and select the mutual fund you wish to buy. Specify the amount you want to invest and submit your order. Mutual fund orders are typically processed at the end of each trading day, with the price per share determined by the fund’s net asset value (NAV) at the close of the market.

The process for selling your mutual fund shares is similar. You place a sell order with the fund company or brokerage firm, and the order is executed at the next available NAV. The proceeds from the sale, minus any applicable fees or taxes, are then credited to your account.

6. Monitor and Manage Your Portfolio

Investing in mutual funds is not a one-time event; it requires ongoing monitoring and management to ensure your portfolio continues to align with your goals and risk tolerance. Regularly review your investments’ performance and compare them to relevant benchmarks and peer funds. If a fund consistently underperforms its benchmark or peers, it may be time to consider selling it and investing in a better-performing alternative. That said, “regularly” doesn’t mean giving yourself the stress of checking on your retirement savings every hour or every day when volatility might lead to temporary losses that you would never notice otherwise.

As your investment goals or market conditions change, you may need to rebalance your portfolio to maintain your desired asset allocation. Rebalancing involves selling investments that have become overweighted in your portfolio and buying investments that have become underweighted to bring your portfolio back in line with your target allocation.

Additionally, stay informed about the mutual funds you own. Read the fund’s annual reports as they are sent to you and stay up to date on any changes to the fund’s investment strategy, management team, or fee structure. If a fund experiences significant changes that no longer align with your investment objectives, it may be necessary to sell your shares and invest elsewhere.

By following these steps and maintaining a long-term perspective, you can effectively invest in mutual funds and work toward achieving your financial goals. Remember, investing in mutual funds involves risk, and it’s essential to research your options thoroughly, understand the costs involved, and make informed decisions based on your circumstances.

Risks and Considerations for Mutual Fund Investors

While mutual funds offer many benefits, such as diversification and professional management, they also have certain risks to be aware of.

Market Risk

Market risk is the possibility that the value of a mutual fund’s investments will decline because of factors affecting the overall financial markets. This risk is inherent in all investments, including mutual funds, and cannot be eliminated. When the market experiences a downturn, the value of a mutual fund’s holdings may decrease, resulting in a lower NAV, potentially lowering your returns.

Inflation

If a mutual fund’s returns do not keep pace with inflation, the real value of the investment may decline. For example, if a mutual fund generates an annual return of 5%, but the inflation rate is 3%, the real return (adjusted for inflation) would be about 2%. Over an extended period, this difference can significantly affect your ability to meet your financial goals.

Cash and Fee Drags

Cash drag refers to the potential negative effect on a mutual fund’s performance because of holding cash or cash equivalents, such as money market instruments or short-term bonds. Mutual funds often keep a part of their assets in cash to meet redemption requests, take advantage of investment opportunities, or maintain liquidity. However, holding too much cash can be a drag on performance, especially during bull markets, when stocks are appreciating.

Fee drag refers to the negative impact of mutual fund fees and expenses on investor returns. Mutual funds charge various fees, such as expense ratios, sales loads, and redemption fees, which can eat into returns over time. Expense ratios, which cover the fund’s operating costs, are particularly important to consider. If a fund has an expense ratio of 1% and generates a 10% return before fees, the investor’s actual return would be 9% after accounting for the expense ratio. High fees and expense ratios can significantly alter returns, especially over long investment horizons.

Fund-Specific Risks

In addition to market risk, mutual funds are subject to specific risks related to their investment strategies and holdings. For example:

1. Credit risk: Bond funds, particularly, are exposed to credit risk, which is the possibility that fixed-income issuers may fail to make interest payments or repay principal when due. As credit risk increases, specific bond holdings may lose value.
2. Liquidity risk: Some mutual funds may invest in less liquid securities, such as small-cap stocks or emerging market bonds, which can be difficult to sell quickly without impacting the price.
3. Concentration risk: Sector or region-specific funds may be more vulnerable to events affecting those particular sectors or regions, leading to higher volatility and potential losses.
4. Currency risk: International funds or those that invest in foreign securities are subject to currency risk, as fluctuations in exchange rates can affect returns.

The Bottom Line

Investing in mutual funds is often an excellent way to grow your wealth over time. By setting clear investment goals, researching and selecting suitable funds, and regularly monitoring your investments, you can start to build a diversified portfolio that aligns with your financial objectives. Mutual funds are available to buy and sell through your brokerage firm or directly from mutual fund companies, so if you’re ready to dive into mutual funds, this guide can get you started.

As with any investment, it’s essential to understand the risks and considerations involved and make informed decisions based on your circumstances. You could also start off your research by seeking a qualified financial advisor.