How to Invest in Mutual Funds: A Beginner's Guide
Mutual funds are investments that combine together investor money to purchase a selection of equities, bonds or other assets. These funds help investors rapidly create a diversified portfolio.
What Are Mutual Funds?
Mutual funds a type of investment that combines together money from many investors, then uses that money to invest in equities, bonds or other assets. Mutual funds are typically administered by a professional who selects the investments.
By enabling investors to buy into many investments with a single transaction, mutual funds can help create more diversified portfolios than most individuals could establish on their own. Index funds, bond funds and target date funds are all categories of mutual funds.
Mutual fund investors don’t directly own the stock or other investments held by the fund, but they do share equally in the profits or losses of the fund’s total holdings — hence the “mutual” in mutual funds.
Why Invest In Mutual Funds?
Mutual funds are a relatively hands-off method to invest in many different assets at once — within a single mutual fund, you could acquire exposure to hundreds of equities, bonds or other investments. Mutual funds are popular among investors who don't want to select and choose individual investments themselves, but want to benefit from the stock market's historically high average annual returns.
Active Vs. Passive Mutual Funds
A mutual fund's fees and performance will depend on whether it is actively or passively managed.
Passively managed funds invest to correspond with a specific benchmark. They attempt to replicate the performance of a market index (such as the S&P 500), and therefore typically don’t require administration by a professional. That translates into reduced overhead for the fund, which means passive mutual funds often carry lower fees than actively managed funds.
Types Of Mutual Funds For Passive Investing
Here are two categories of mutual funds popular for passive investing:
Index funds are made up of equities or bonds that are listed on a particular index, so the risk attempts to mirror the risk of that index, as do the returns. If you own an S&P 500 index fund and you learn that the S&P 500 was up 3% for the day, that means your index fund should be up about that much, too.
Exchange-traded funds can be traded like individual equities, but offer the diversification benefits of mutual funds. In many circumstances, ETFs will have a lower minimum investment than index funds. ETFs may be more tax-efficient than index funds.
Actively managed funds have a professional manager or management team making judgments about how to invest the fund's money. Often, they attempt to outperform the market or a benchmark index, but studies have shown passive investing strategies often deliver higher returns.
How To Invest In Mutual Funds
If you're eager to invest in mutual funds, here is our step-by-step guide on how to buy them.
1. Decide whether to go active or passive
Your first choice is perhaps the biggest: Do you want to surpass the market or attempt to mimic it? It's also a fairly simple choice: One approach costs more than the other, often without delivering superior results.
Actively managed funds are managed by professionals who research what's out there and buy with a view toward defeating the market. While some fund managers might accomplish this in the short term, it has proved difficult to outperform the market over the long term and on a regular basis.
Passive investing is a more hands-off approach and is increasing in popularity, due in large part to the simplicity of the process and the results it can deliver. Passive investing often entails fewer fees than active investing.
2. Calculate your limit
Thinking about your budget in two ways can help determine how to proceed:
How much do mutual funds cost? One appealing thing about mutual funds is that once you meet the minimum investment amount, you can often choose how much money you’d like to invest. Many mutual fund minimums range from $500 to $3,000, though some are in the $100 range and there are a few that have a $0 minimum. So if you choose a fund with a $100 minimum, and you invest that amount, afterward you may be able to elect to contribute as much or as little as you want. If you choose a fund with a $0 minimum, you could invest in a mutual fund for as little as $1.
Aside from the required initial investment, ask yourself how much money you have to comfortably invest and then choose an amount.
Which mutual funds should you invest in? Maybe you’ve decided to invest in mutual funds. But what initial combination of assets is appropriate for you?
Generally speaking, the closer you are to retirement age, the more holdings in prudent investments you may want to have — younger investors typically have more time to ride out speculative assets and the inevitable downturns that happen in the market. One kind of mutual fund takes the uncertainty out of the “what's my mix” question: target-date funds, which automatically reallocate your asset mix as you age.
3. Decide where to purchase mutual funds
You need a brokerage account when investing in equities, but you have a few options with mutual funds. If you contribute to an employer-sponsored retirement account, such as a 401(k), there’s a high possibility you’re already invested in mutual funds.
You also can buy directly from the company that created the fund, such as Vanguard or BlackRock, but doing so may limit your choice of funds. You can also engage with a traditional financial advisor to purchase funds, but it may incur some additional fees.
Most investors opt to purchase mutual funds through an online brokerage, many of which offer a comprehensive selection of funds across a range of fund companies. If you go with a broker, you'll want to consider:
Affordability. Mutual fund investors can confront two types of expenses: from their brokerage account (transaction fees) and from the funds themselves (expense ratios and front- and back-end “sales loads”). More on these below.
Fund options. Workplace retirement plans may hold only a dozen or so mutual funds. You may want more variety than that. Some brokers offer hundreds, even thousands, of no-transaction-fee funds to choose from, as well as other forms of funds like ETFs.
Research and educational instruments. With more choice comes the need for more pondering and inquiry. It's vital to decide a broker that aids you learn more about a fund before investing your money.
Ease of use. A brokerage's website or app won't be useful if you can't make heads or tails of it. You want to comprehend and feel comfortable with the experience.
4. Understand mutual fund fees
Whether you choose active or passive funds, a company will charge an annual fee for fund management and other costs of operating the fund, expressed as a percentage of the cash you invest and known as the expense ratio. For example, a fund with a 1% expense ratio will cost you $10 for every $1,000 you invest.
A fund’s expense ratio isn’t always simple to identify upfront (you may have to sift through a fund’s prospectus to find it), but it's well worth the effort to comprehend, because these fees can cut into your returns over time.
Mutual funds come in various structures that can impact costs:
Open-end funds: Most mutual funds are this variation, where there is no limit to the number of investors or shares. The NAV per share rises and declines with the value of the fund.
Closed-end funds: These funds have a limited number of shares offered during an initial public offering, much as a company would. There are far fewer closed-end funds on the market compared with open-end funds. A closed-end fund’s transaction pricing is quoted throughout the day on a stock exchange. That price may be higher or lower than the fund’s actual value.
Whether or not funds bear commissions is expressed by “loads,” such as:
Load funds: Mutual funds that pay a sales charge or commission to the broker or representative who sold the fund, which is typically passed on to the investor.
No-load funds: Also known as “no-transaction-fee funds,” these mutual funds charge no sales commissions for the purchase or sale of a fund share. This is the greatest bargain for investors, and online brokers often have thousands of choices for no-transaction-fee mutual funds. Most funds available to individual investors are presently no-load.
5. Manage your portfolio
Once you determine the mutual funds you want to buy, you'll want to consider about how to manage your investment.
One move would be to rebalance your portfolio once a year, with the aim of maintaining it in accordance with your diversification plan. For example, if one portion of your investments had tremendous gains and now constitutes a larger share of the pie, you might consider selling off some of the gains and investing in another slice to regain balance.
Sticking to your plan also will prevent you from pursuing performance. This is a risk for fund investors (and stock experts) who want to get in on a fund after reading how well it did last year. But "past performance is no guarantee of future performance" is an investing cliche for a reason. It doesn't mean you should just remain set in a fund for life, but pursuing performance almost never works out.
Mutual Fund Categories
Beyond the active and passive designations, mutual funds are also divided into other categories. Some mutual funds focus on a single asset class, such as equities or bonds, while others invest in a variety. These are the primary categories of mutual funds:
Stock (equity) accounts
Typically bear the greatest risk alongside the greatest potential returns. Fluctuations in the stock market can significantly affect the returns of equity funds. There are several varieties of equity funds, such as development funds, income funds and sector funds. Each of these groups attempts to maintain a portfolio of securities with certain characteristics.
Stock (value) accounts
Seek to invest in companies that are determined to be undervalued based on the company's fundamentals.
Balanced funds invest in a blend of stocks, bonds and other securities. Balanced funds (also called asset allocation funds or hybrid funds) are often a “fund of funds,” investing in a collection of other mutual funds. One popular example is a target-date fund, which automatically selects and reallocates assets toward safer investments as you approach retirement age.
Blended funds
These include a blend of value and growth equities, or those that offer significant earnings growth.
Bond (fixed-income) accounts
Bond funds are typically less hazardous than equity funds. There are many various varieties of bonds, so you should research each mutual fund individually in order to determine the amount of risk associated with it.
Money market funds
These products often have the lowest returns because they bear the lowest risk. Money market funds are legally required to invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations.