Table Of Contents
- A mutual fund is a diversified investment where investors contribute money to collectively invest in a specialized group of stocks, bonds, and other securities
- Mutual funds come in all shapes and sizes, with varying degrees of risks and investment targets designed to appeal to different types of investors
- You can invest in a mutual fund through a compatible employer-sponsored plan, financial advisor, mutual fund company, or financial advisor
- Mutual funds have risk like any other investment but can be worthwhile for many investors depending on your financial situation
What Is A Mutual Fund?
A mutual fund is a company that takes in money from investors to collectively purchase stocks, bonds, and other assets. These investments are heavily diversified since the collective mutual fund can invest in multiple different stocks, whereas an individual investor has more limited options.
Mutual funds can be broken down into active and passive funds. Active mutual funds are managed by professional fund managers. These managers work to outperform the market based on their financial expertise. On the contrary, passive funds are based on a set index like the Dow Jones. Passive funds require less active management, and therefore often have lower fees than active funds.
Mutual funds come in many shapes and sizes, designed for the various goals of individual investors.
Understanding The Different Types Of Mutual Funds
You’ll have to choose between opting for an actively or passively managed portfolio. Active funds are run by a financial professional or team, typically at a higher fee, who make investment decisions based on their expertise. Passive funds are invested based on a market benchmark like the S&P 500.
Outside the broad active and passive categories, you’ll come across various fund categories. These various fund categories are broken down by the target goal for the mutual fund. This list isn’t exhaustive, but here are some of the more common types you’re likely to encounter:
- Money Market Funds: Money market funds are known for being some of the most secure mutual funds available since investment is dedicated to solid, low-risk investments like treasury bills. These funds won’t provide substantial returns, but they are known for their stability.
- Income Funds: These funds are designed to provide more liquid, cash flow for its investors.
- Index Funds: Mutual fund that invests based on a major market index like the Dow Jones Average or S&P 500
- Bond Funds: Active mutual fund that focuses on purchasing assets with a set rate of return like bonds
- International/Global Funds: This fund invests in assets outside of your country of residence
- Target Date Funds: Focused on a target year to withdrawal, usually optimized for retirement purposes
How To Invest In A Mutual Fund
1. Choose Between Active Or Passive Funds
The first step is to choose between an active or passive mutual fund. Active funds are run by financial experts or individuals who try to outperform the market. Passive funds utilize an index of the market as it currently stands, so they do not require direct management. In contrast to active funds, passive funds don’t trade as often and tend to carry fewer fees since there is no active fund management.
2. Determine Where You Want To Buy Funds
Plenty of investors choose to buy mutual funds through an online brokerage. Some of these brokerages that you might’ve heard of in the past include Vanguard, Fidelity, and E-trade. Note that each brokerage comes with its own fee structures, fund choices, and level of accessibility, so make sure you find the right brokerage for your needs.
If you contribute to an employer–sponsored retirement account like a 401(k), you might already be investing in a mutual fund.
3. Build Around Your Budget
When selecting a mutual fund, read that fund’s prospectus, which provides detailed information on your fund of choice. This will help you determine what fees are required, understand any special terms, and account for any buy-in minimums. Some mutual funds require you to deposit a minimum amount, usually ranging from $500 to $3,000 to start investing in the fund.
Fees related to using an active or passive mutual fund are known as an expense ratio. The expense ratio pays for the costs associated with managing the fund, which is why active mutual funds have a higher ratio. This amount is usually expressed as an annual percentage fee. If you had $5,000 in an account, and the expense ratio was 1%, your annual fee would be $50.
4. Continue Diversifying Your Portfolio
Many investors like mutual funds because they are inherently diversified. Having a diversified portfolio helps minimize risk since if one area has a downturn, it’s likely not a huge blow in proportion to the rest of your portfolio. Essentially, don’t put all of your eggs in one basket.
However, there are plenty of different types of mutual funds, with varying degrees of risk. Make sure to invest according to the context of your full portfolio, not just in relation to any individual fund.
Pros And Cons Of Mutual Funds
Mutual funds come with their own sets of pros and cons. Some of the benefits of mutual funds include:
- Diversification: Mutual funds provide a level of diversification that is challenging to achieve by an individual investor. This can spread out risk and help lessen the blow of any potential losses.
- Hands-off Investing: The cost of managing mutual funds is baked into the fees of the investment. Your portfolio is managed by financial experts, making it a lot less daunting for some investors as opposed to investing in individual stocks.
- Low Minimum Investment: Unlike ETFs or exchange-traded funds, mutual funds can be purchased in partial or full shares. There might be a minimum buy-in amount to start your investment, but beyond that, mutual funds are pretty approachable.
On the flip side, some potential drawbacks to investing in mutual funds include:
- Limited Control: As a shareholder, you don’t have much control over what you’re investing in with mutual funds since they are managed by a company.
- Fees: You might be subject to paying capital gains tax depending on your investment. Mutual funds also come with fees and usage limitations.
- Risk: Though mutual funds tend to be more reliable than individual stocks depending on the situation, they aren’t without risk. There is no guarantee you’ll receive gains on your income, even with a more conservative fund.
Mutual Fund FAQs
How Does A Mutual Fund Work?
A mutual fund works by pooling, or taking in money from multiple investors to collectively invest money in several stocks, bonds, and other securities. This money is regularly managed by financial experts who try to earn returns on income.
Are ETFs And Mutual Funds The Same Thing?
Mutual Funds and Exchange-traded Funds both operate as a collection of individual investments or securities, managed by financial experts on behalf of their respective shareholders. However, mutual funds are bought and sold based on dollar amounts while ETFs can only be traded in shares, similar to stocks. Mutual funds come at a higher cost since there are usually financial experts actively managing the portfolio.
Are Mutual Funds Safe?
Safety is relative, but mutual funds are considered safer than investing in individual stocks because it’s an inherently diversified investment. You’re more protected if one of the stocks in your mutual fund tanks since that is only a portion of the mutual fund portfolio. As with any investment, mutual funds still come with risk and are subject to fluctuate based on market conditions.
Can You Sell Mutual Funds At Any Time?
Any transaction relating to mutual funds will be conducted at the end of the day based on the fund’s NAV or net asset value. Some mutual funds may have a minimum holding period before you can sell shares since they are usually meant to be long-term investments. Those who sell mutual funds before the minimum holding period are subject to fees and other consequences.
In short, mutual funds may make a great investment for your portfolio depending on your goals. These investments are well-diversified and optimized for long-term investing.