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- You can start investing in mutual funds and choose between active or passive investing strategy.
- Mutual funds are typically actively managed, but there are passive mutual funds like index funds.
- When you invest in mutual funds be aware of sales loads and expense ratios fees, which can add up.
Investing your money can help you turn one dollar into many more, giving you the ability to build wealth without having to work harder. Thanks to compound interest and the wide range of investment vehicles, you can decide where to put your money.
One type of investment vehicle that can help diversify your money is a mutual fund, which pools the money contributed by many different investors. These funds invest in various securities like stocks, bonds, and short-term debt. There are two types of mutual funds, ones that are actively managed, and ones that are passively managed.
Understanding Mutual Funds
What are mutual funds?
According to the Securities and Exchange Commission (SEC), a mutual fund is an open-end investment company that is registered with the SEC and gathers money together from various investors to put into asset classes like stocks, bonds, and more.
By using this approach, mutual funds can grant investors quick exposure to diversified portfolios of assets. Mutual funds rely on a team of portfolio managers and research analysts to make investment decisions.
Unlike shares of stock, you can purchase shares of a mutual fund directly through the fund provider. Buying one of these shares provides you with partial ownership of the fund's total portfolio.
These funds are widely used by investors. As of 2022, more than $22 trillion were invested in mutual funds, according to Statista data. Further, as of the following year, 52% of U.S. households were invested in these funds, according to figures from the Investment Company Institute.
The price of a mutual fund is determined by calculating its net asset value (NAV), which can be done by adding up all of its assets and then subtracting its liabilities.
Benefits of mutual funds
Mutual funds can provide investors with quick exposure to a diversified portfolio of assets. Further, by pooling the resources of different investors, individuals who buy shares of these funds can access the benefits of professional investment management teams for a reasonable cost.
Steps to investing in mutual funds
Step 1: Determine your goals and risk tolerance
Before you get started with investing in mutual funds, it's important to first review your current income, expenses, monthly debt obligations, and net worth to see where you're at financially.
You wouldn't build a house without laying a proper foundation — and the same goes with your finances. Having an emergency fund and manageable debt are important if you want to invest. Why? Because investing is risky, no matter how you look at it. There are ways to minimize your risk by figuring out your risk tolerance, but it's crucial you have that financial foundation and safety net set up.
Knowing where your finances are at now can inform how much you can afford to invest and what your asset allocation should be based on your risk tolerance.
On top of that, consider your short- and long-term goals when investing. Will this be used for a down payment in five years or for your retirement in 30 years? Knowing your goals and having a rough timeline can ensure that you stay on track and know 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.
Stock funds: These invest in shares of companies. There are some nuances within stock funds, including those that focus on investing in growth-focused stocks based on financial returns, income-focused stocks that produce dividend payouts, stock funds based on certain sectors, as well as index funds that track specific indexes and seek to produce similar results.
"Mutual funds are baskets of various stocks with a common theme behind them, such as 'US Equities Growth Fund' or 'Sustainable Developed Markets Fund.' They usually have a net asset value, which is determined once per day, unlike stock prices that fluctuate during the day in the markets," explains Gary Grewal, a CERTIFIED FINANCIAL PLANNERTM and author of "Financial Fives: The Top 325 Ways to Save, Earn, and Thrive to Retire Before 65."
Bond funds: This is a type of investment company that's focused on investing in bonds and debt securities. The risk related to bonds can differ depending on the bond. As an investor, the SEC recommends that you consider the credit risk, meaning the risk that the lender will default, as well as prepayment risk, meaning the risk that the bond issuer pays back the bond earlier than anticipated.
Money market funds: These have the least risk and invest only in investments that are high-quality and short-term.
Target-date funds: These contain a combination of stocks and bonds that aim to help you retire by a certain date, called target-date funds. They can also be referred to as lifecycle funds. These funds will shift their allocation between different assets over time in order to achieve their overall goal.
In many cases, mutual funds are actively managed by a team of investment professionals. But it's possible to invest passively in mutual funds as well, typically called an index fund. Also: mutual funds can be index funds — and vice versa.
Actively managed mutual funds use their management team in an effort to beat the market.
Passively managed funds like index funds have an objective to match the results of a particular index and don't have a professional manager. As such, it's a passive way to invest as there's no outside help. No outside help typically means lowers costs.
In order to diversify your investments, you'll want to invest in various types of mutual funds and not just one type in a specific sector.
After researching the various types of mutual funds out there, you want to be clear about whether you want to have a passive or active strategy.
Actively managed mutual funds are costlier, as they are rife with fees, can take a chunk out of your investments, and may also lead to tax events.
For example, there may be mutual fund distributions that you need to report and pay taxes on. When you invest in mutual funds, you can get capital gains distributions as well as dividend payments. This could be a good thing, but there may also be tax implications.
Depending on what your mutual fund manager does, it could lead to higher taxes because of the difference in holdings.
When you sell an asset, you're expected to pay capital gains taxes if you hold the asset for longer than a year and there is an increase in value. If you hold it less than that, you'll be taxed at the ordinary income rate, which is higher (which can be up to 37% compared to 20%).
Passively managed mutual funds, such as index funds, seek to replicate market returns of a particular index, such as the ever-popular . They are more affordable for investors since there are no fees that go toward paying for a management team.
"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," explains Grewal.
In many cases, actively managed funds don't actually outperform passively managed funds in the long run.
"Multiple studies have shown over time it's very hard to beat the market, so passive funds such as those that track the S&P 500 Index may be a better choice for those concerned about fees, as passive funds have expense ratios that are typically much lower than their active counterparts," says Grewal.
To consider the impact and costs you can use the Fund Analyzer tool by the Financial Industry Regulatory Authority, or FINRA. You can also look at the mutual fund's prospectus to get a breakdown of fees, risks, and overall performance. For both active and passive mutual funds, you also want to consider the expense ratio, which includes costs related to managing your account.
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," notes Grewal.
Most investors use brokerage accounts to buy mutual fund shares. You can check out some popular options such as Fidelity, Vanguard, Charles Schwab, and Etrade. Before opening an account, be sure to review the prospectus and any fine print and also consider:
- Any account minimums required
- Usability of website and mobile app options
- Funds that are available
- Total costs such as sales load and expense ratio
After you open an account with a brokerage, deposit the money you need for the transactions you have in mind.
Another option is using a retirement account like a 401(k) or Roth IRA.
Alternatively, you can set up a mutual fund account directly with the company offering the fund in question.
Step 4: Purchase your fund shares
After researching types of mutual funds and choosing a strategy, you want to get started investing in mutual funds.
How much you end up paying will vary based on the sales charge or sales load as well as the fund's net asset value per share. You may be able to invest in mutual funds that don't have a sales load associated with them as well.
You may want to develop a plan to add funds on a regular basis, 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)
Once you have purchased some mutual fund shares, you can keep track of their performance. What might be far more effective than watching how they change value every day is evaluating their performance on a monthly, quarterly, or annual basis.
Rebalancing is the process of 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 having an allocation of 60% stock mutual funds that invest in stocks and 40% bond mutual funds.
If stocks have a good year, for example, it could cause the allocation to change to 66% stock mutual funds and 34% bond mutual funds, at which point an investor might want to rebalance by either selling some of their stock-related funds and/or buying more bond-focused mutual funds.
Rebalancing one's portfolio on an annual basis is the most effective method for many investors, according to Vanguard research. This approach can coincide with less transaction fees than rebalancing more frequently.
How to Invest in Mutual Funds FAQs
Are mutual funds a safe investment?
Risk is inherent to investment, but by putting your money into mutual funds, you can obtain quick diversification.
How much should I start investing in mutual funds?
There are a wide range of mutual funds that require no minimum initial investment. Any amount you can contribute to these funds regularly can be a good place to start.
What are mutual fund fees?
Mutual funds come with expense ratios, which are basically management fees, and loads, which are basically sales fees. An expense ratio is a fraction of your investment that you pay every year.
Do mutual funds pay dividends?
Many mutual funds pay dividends, providing their owners with a potential source of income.
Are mutual funds good for retirement?
Mutual funds can be an excellent tool for retirement planning, as they can provide significant diversification and exposure to a wide range of assets.
MelanieLockertis the founder of the blog and author of the book, "Dear Debt." Through her blog, she chronicled her journey out of $81,000 in student loan debt. Her work has appeared on Business Insider, Time, Huffington Post and more. She is also the co-founder of theLola Retreat, which helps bold women face their fears, own their dreams and figure out a plan to be in control of their finances.
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