Mutual funds are investment companies that pool money from multiple people and make investments according to their collective decisions. Mutual funds are easy to set up, cheap to run, and offer a good way for investors looking for diversification of their portfolios since a single fund can hold a lot of different types of stocks or bonds.
Asset classes can range from holding a mix of index funds, exchange-traded funds (ETFs), money market funds, equity funds, and more.
Mutual funds have taken over from stocks in the last few decades as a dominant investment vehicle.
Keep reading to find out how you can start investing in mutual funds and the steps to follow to do it right.
Decide on your mutual fund investment goals
What’s most important is that you have an idea of your reason for investing. Here are a couple of examples of goals you might have.
- Make money: Look at the funds with the highest expected return or the ones that are likely to give you the best returns over time.
- Save for retirement: If you’re investing in mutual funds for the long run, then it’s worth looking at some funds that are likely to give you reasonable returns even if they don’t do particularly well in the short term.
- Invest safely: If you want a safer investment in line with the market, you should choose index funds.
- Invest wisely: If you’re just starting and want to take some risks, then there’s no need to pick one particular firm: look for sensible companies which are good investments over time.
Investing is a skill that requires understanding risk and reward and opportunity cost; it’s not something most people know anything about. However, knowing your investment goals from the get-go will help you make smart choices.
The best approach is to divide your goals into three broad categories:
- Long-term investments: these are investments you want to hold for more than ten years. Long-term goals include target-date funds, such as retirement plans. They last for decades, and you expect to have sufficient resources to take care of yourself when they expire. An investment in a mutual fund that offers you a diversified portfolio is the best way to meet this goal.
- Mid-term investments: these are investments you want to hold for up to five years. Mid-term goals are the ones most people have now that they didn’t have before: a down payment on a house, saving for college or retirement, or setting aside money for other things that will happen in the future. In general, these goals shouldn’t be too short-term (you want to make sure you can afford them), but they shouldn’t be too long-term either (what will happen tomorrow?).
- Short-term investments: these are investments whose goals are closer in term-date, maybe within a few years. Short-term goals are the kind that get all the attention these days — savings for an emergency or vacation.
Pick the right investment strategy: active vs. passive
Mutual funds are a good way to build wealth. You build your fund by investing in other people’s funds. All you have to do is pick the right kind of mutual fund for you.
Active
It is easy to pick the wrong investments but hard to pick the right ones. Perhaps the easiest way to pick the wrong investment is not to pick one at all. If you feel this way, active investing may be the best for you.
In this category, you have investment managers do the investing for you. Also known as portfolio managers, they usually charge a fee per year per account, then take a small percentage of whatever their clients’ investments grow. Their goal is to try and beat the market and, as such, charge higher fees.
The main argument for active funds is that the market changes so often that you can’t be sure what the best strategy will be. Having an investment advisor onboard will help guide your investments beyond the market benchmark and make higher returns.
Passive
In passive investing, you don’t try to beat the market. It takes only two minutes to buy a mutual fund, after which it does all the work for you: investing your money so that it grows without fail, year after year, decade after decade. The risk is small and the reward huge: you can expect to earn 15% more over a lifetime than if you were just sitting in cash doing nothing.
Passive funds argue that indexing is a better strategy than picking the stocks yourself. Sure, you might not have an investment professional onboard, but a passive fund’s expense ratio is often lower.
Perhaps the most important thing is to pick something that fits your temperament. The most successful investors seem to be people who have a reasonably good idea of what they are doing, have a plan and stick with it, and don’t get frustrated when things don’t work exactly as they thought they would.
Research the best mutual funds for you
You have to do some basic research to find a mutual fund that suits your goals. A go-to strategy is to read the mutual fund’s prospectus to understand its investment objectives, past performance, portfolio, and gains and net asset value (NAV) distributions to shareholders.
Remember the categories from Step One? Mutual funds can be divided based on those too:
- Mutual funds for long-term goals are often growth funds. They may have more risk but, in the long run, can provide substantial capital gains. An example is the Vanguard Growth Index Fund.
- Balanced funds are your best go for mid-term goals. They offer both equity and debt instrument, offsetting risk and giving you a ‘balanced’ approach to your investments. An example is the American Funds American Balanced Fund.
- For short-term investment goals, consider debt funds and money market instrument investments. As they have low risk and low returns but provide steady income. An example is the Vanguard Equity Income Fund.
Understand mutual fund fees
If you want to invest your money wisely to make more money later, you have to consider the fees associated with mutual funds.
- Expense ratio: the percentage of investment returns that goes to fund management fees instead of investing them in stocks or bonds or whatever else you hold in the fund.
- No-load funds: You do not have to pay sales commissions, whereas with load funds, for every purchase or sale of a share, there is a brokerage fee connected to it. The back-end fees are much lower.
- Transaction fees: These are incurred when you are trading and investing regularly. Due to higher active trading volumes, active funds tend to have higher transaction fees.
Open an investment account
A lot of the money in mutual funds is invested by employers in retirement plans, so that’s how most people get access to them.
Employer-sponsored
Employer-sponsored retirement accounts have a couple of advantages. They are easy to join and have built-in economies of scale: newly hired employees pay a percentage of their salaries into the bank account as a loan and as interest accumulates over the years the employees get money back. The bank makes a profit on this side of the transaction. That’s why you can check how much money is in your account and how much interest you’ve earned.
Do it yourself
But if you’re not in a plan, or if you don’t have one, then you can invest in funds yourself.
For example, as an employee of a small business, you probably will not get a retirement plan. If you want to save, the best way is to open a brokerage account on your own.
A brokerage account is the easiest way to invest in mutual funds, and it is generally easier than setting up a self-directed IRA. You can start investing directly in mutual funds with as little as $1,000. Self-directed IRAs are still useful if you have a lot of money to invest, as they allow more control than a brokerage account but are more complicated.
Other types include taxable brokerage accounts and education savings accounts for your children.
Purchase shares of the mutual fund you’ve chosen
The first thing to do is to make sure your investment account has enough money in it. Many mutual funds require higher minimum investments for their more advanced offerings.
The minimum investment is the minimum amount you have to have in your account. If you’re not ready to make a big investment, don’t make it. You might find that you need to move back to a lower-cost fund and start over.
Keep in mind that mutual funds also only trade once per day after the market closes. So you should time your purchases accordingly.
Of course, this is something your investment manager will do on your behalf if you opt for active investing.
Create a consistent investment plan
If you want to invest, the best strategy is to make a regular plan. If you’re investing for a long time, you don’t want to have to remember to deposit money every week or month.
For example, let’s say you already know that you need $200 a month for retirement. Set up a recurring deposit from your bank account and never think about it again. This can also be useful if you want to buy some stock or mutual fund that you don’t know how often the price will change, so you’ll probably want enough money to cover your maximum losses if the price drops right away.
You can set up a recurring investment plan on your brokerage trading platform or website with no cost at all. As long as your brokerage accepts electronic payments, they should be able to do this for you gratis.
If you need more than that, the broker should be able to help you set it up on an automated basis with their trading platform (which should include software for setting up automatic deposits).
Have an exit strategy ready
Mutual funds are a popular way to invest in stocks. They are also fairly easy to understand and get started with, which makes them appealing to people who don’t have investing experience. But if you don’t carefully plan for when you’ll sell your fund shares, you could easily find yourself locked into a losing position.
Too often, people who own mutual funds don’t check in with the managers of their accounts to see what they are doing. The result is that they are constantly surprised by the twists and turns of the market and can end up investing in the wrong things just when they need their money.
Here are some steps you can take:
- Examine your current investments every year or two. Ask yourself how long you intend to keep them. If you’re not sure, you might want to sell some of your holdings and place new ones in a different type of mutual fund.
- Decide how often you’ll check up on the assets you’re putting into your account. It’s best if you do it at least once a year, though once every six months will probably suffice for most investors. This practice will give you a chance to see how much your portfolio has changed since you last looked at it.
- Check on your asset allocation. Your asset allocation is the percentage of your portfolio invested in different categories of investments.
- Do some portfolio rebalancing. It’s a good way to balance your risk and not just count on your managers to achieve their goals via stock market returns.
- Have a financial advisor on board that you can confer with. Someone who knows the ins and outs of investment products, risk tolerance, and how the market works can benefit you in the long run, especially if you’re looking to have low-cost strategies with high returns.
FAQs
What are mutual funds?
Mutual funds are one of the most popular investment vehicles in the world. A mutual fund is a pool of money managed by a professional manager. When you buy shares in a mutual fund, you give the manager permission to use your money as he sees fit to make investments in the stock market.
How do mutual funds work?
There are roughly two ways to invest in mutual funds. You can use the services of a fund manager to do it for you, or you can do it yourself on your computers. The first option is usually much less expensive than the second.
Can you lose money in mutual funds?
Investing in mutual funds carries less risk than investing in individual stocks. This is because a mutual fund company invests your money for you, usually with borrowed money from banks or other investors. Individual investors who become shareholders and invest directly in stock funds thus risk losing it if the individual companies they own go bankrupt. However, you can still lose money if you don’t carefully manage your investments in the fund.