So you’ve managed to build up some savings, and now you want to make the most of your hard-earned cash by investing it.
Where do you begin?
That’s where mutual funds come in.
Managing a stock portfolio is time-consuming and — more importantly — risky. By delegating the hard work and stress of managing a diversified portfolio to professionals, you can sit back and watch your investments grow.
If you’re ready to start investing in mutual funds, this guide is here to help. You’ll learn about the different types of mutual funds, how to evaluate them, and where to buy them.
Understanding Mutual Funds
Mutual funds are financial products offered by investment companies that pool together money from different clients and invest it into various assets like stocks and bonds. These assets are packaged in different types of professionally managed investment portfolios. Portfolios vary depending on investment goals, risk tolerance, market sector, and other factors.
Mutual funds offer diversification to individual investors at a relatively low cost. Diversification means the money in a fund is distributed across various investments and is less risky than investing in individual stocks.
When you buy mutual fund shares, you become a partial owner of the fund, and your share prices increase and decrease according to the fund’s net asset value (NAV). A fund’s NAV indicates its overall market performance and determines the cost of buying or selling your shares.
Mutual funds can also provide income in the form of dividends or capital gain, which are either paid back to you or reinvested in your shares of the fund.
Types of mutual funds
Passive vs. active
Mutual funds come in two different management styles: passive and active.
Passively managed funds offer similar diversification to other mutual funds but require little to no professional management and often have lower fees than actively managed funds. Index funds and exchange-traded funds (ETFs) are both increasingly popular passive investments because of their flexibility, consistent performance, and tax efficiency.
On the other hand, active funds are managed by a team of professional fund managers who try to outperform the market by actively buying and selling assets throughout the day. Most mutual funds fall into this category.
Classes of mutual funds
Mutual funds can further be categorized based on the asset classes they invest in, or their asset allocation: equity, debt, or a mix of the two.
Equity funds (stocks)
Equity funds are the most common type of mutual funds. They carry the most investment risk and the most potential gain.
Equity funds are preferred for long-term investment objectives like retirement plans and college funds because these allow the investor to ride out short-term market fluctuations and benefit from the market’s overall growth.
Fixed-income funds (bonds)
Fixed-income funds invest in debt securities like corporate bonds, high-yield bonds, municipal bonds, or U.S. Treasury securities. These are less risky than equity funds, but they offer less potential growth. These are more attractive to those who want to retrieve their money in the short term, like recent retirees.
Money-market funds
Money-market funds are the safest type of fund because they invest in high-quality, short-term debt securities issued by the U.S. government and U.S. corporations. They provide a stable but limited return on investment, which is usually only a bit more than a typical savings account.
Balanced funds
Also known as hybrid or asset allocation funds, balanced funds invest in a combination of the above three categories.
Some balanced funds offer fixed asset allocation, while others follow a dynamic allocation strategy to respond to market conditions, business cycle changes, or investor priorities. Target-date funds are a dynamic asset allocation because they automatically reallocate assets from equity to debt as you approach retirement.
How and where to invest in mutual funds
Here are a few pointers to follow to help you get the most out of your mutual funds:
Set your investment strategy
Are you investing in a long-term retirement plan or your child’s college education? Or do you want to generate income in the short term for an upcoming purchase? Are you putting most of your savings into investments, or only a small portion? Do you want to passively or actively manage your investments?
The answers to these questions will help you decide what kind of mutual fund is best for you. Long-term goals are better suited to equity-based funds, while bonds and money-market funds are more appropriate for short-term goals.
Do your research
You’ll find most of the essential details about a mutual fund’s performance in the fund’s prospectus, which you can obtain directly from any company offering the fund. Take the time to compare different funds to see how well they respond to your needs.
Remember that some mutual funds also require a minimum investment to buy shares, which means you’ll need to save up before buying in. If you’re just getting started, you should look for mutual funds with no minimum account balance.
Costs are a vital factor to consider when shopping for a mutual fund because they can eat into your returns on investment. Look for the lowest expense ratios and load fees.
No-load funds don’t charge any load fees, and you should be looking for an expense ratio between 0.25 percent and 2 percent. Funds with backend loads don’t charge load fees on transactions, but they do charge on withdrawals. Keep an eye out for brokerage commissions, too, which can sometimes range from $10 to $75 per trade.
Shop around
If you have a retirement account with your employer, like a 401(k) or 403(b), you probably already have access to a selection of mutual funds.
If not, you have two options: you can buy shares of a mutual fund directly from the fund company that created it, or you can open a brokerage account to get access to many different funds.
When shopping for an online broker, consider the number of different funds they have on offer, the research and educational tools they provide, the accessibility and ease of use of their platform, minimum account requirements, and their operating expenses, like trading fees or brokerage commissions.
Broker-dealers are financial advisors selling investments like mutual funds that can help you decide which to buy. Many now offer online platforms and trading apps that allow investors to manage all their investments in one place.
TD Ameritrade, E*Trade, and Merrill Edge are among the most popular online platforms that offer thousands of mutual funds with zero trading fees and no account minimum.
Opening an online account is quick and relatively easy. Just sign up, transfer funds into your account, and you’re ready to start investing.
Frequently asked questions
Why should I invest in mutual funds?
Mutual funds offer many advantages, like affordability, diversification, and professional management.
It’s easy to begin investing in mutual funds because you can often buy a fraction of a share at a lower cost instead of an individual stock. Your money is spread out across various asset classes and market sectors, meaning you’re less exposed to risk, and you can rest easy knowing that a team of professional fund managers is handling your portfolio.
Can you lose money in mutual funds?
All investments carry some degree of risk, and mutual funds are no exception. Make sure you know what you’re investing in; the value of a fund is only equivalent to the value of the assets it contains. But mutual funds also offer the added security of diversification, meaning that the fund’s value remains relatively stable even if one sector of the market performs poorly.
How to choose a mutual fund to invest in?
Your investment objectives, time constraints, and risk tolerance determine which mutual fund is best for you.
Index funds are a good, basic mutual fund for beginners because they offer the same diversification as actively managed mutual funds but charge lower expense ratios. That means you get more for your money.
Final thoughts
Mutual funds are a simple, low-cost way to gain exposure to a diversified portfolio of assets and can be an important part of a balanced budgeting plan. Having various funds to choose from ensures you’ll find one that caters to your specific investment objectives.
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