A Beginner's Guide To Mutual Funds Via Investopedia

Mutual funds are a popular investment choice, especially for beginners, as they offer a simple, accessible, and diversified way to enter the investing world. They are a convenient way for individuals to invest in a diversified portfolio of securities.

Mutual funds pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional fund managers and provide investors with access to a wide mix of assets. Mutual funds give individual investors exposure to a professionally-managed portfolio, potentially benefiting from economies of scale while spreading risk across multiple investments.

There are several types of mutual funds, including equity funds, bond funds, balanced funds, money market funds, index funds, and target-date funds. Each type has its own investment strategy, risk profile, and investment goals, catering to different investor needs.

Investing in mutual funds typically involves setting investment goals, choosing the right funds, opening an investment account, purchasing shares, and regularly monitoring and managing the portfolio. It is important for investors to consider their financial goals, risk tolerance, time horizon, and budget when selecting mutual funds.

Mutual funds offer benefits such as diversification, professional management, and convenience but also carry certain risks, including market risk, fee drag, and credit risk.

Overall, mutual funds provide a practical and cost-efficient way for individuals to build a diversified investment portfolio.

Understand the different types of mutual funds

There are several types of mutual funds, each with its own investment strategy, goals, and risk profile. Here are some of the main types:

• Equity Funds: Also known as stock funds, equity funds invest in publicly traded companies with the goal of increasing the value of your investment by putting money into companies expected to grow. They can be categorized by market capitalization (large-cap, mid-cap, small-cap), investment style (growth, value, blend), and geography (domestic, international).
• Bond Funds: Bond funds invest primarily in fixed-income securities, such as corporate, government, and municipal bonds. They aim to provide regular income and add stability to a portfolio. They can be categorized by the type of issuer, credit quality, and duration of the bonds.
• Balanced Funds: Also known as hybrid funds, balanced funds invest in a mix of stocks and bonds to offer both growth and income. The allocation between stocks and bonds depends on the fund's investment strategy and risk profile, with a common allocation being 60% in stocks and 40% in bonds.
• Money Market Funds: Money market funds invest in short-term, low-risk debt securities, such as Treasury bills, certificates of deposit (CDs), and commercial paper. They aim to maintain a stable value and provide a low-risk, liquid investment option. They are often used for short-term savings or as a temporary holding place for cash.
• Index Funds: Index funds passively track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. They aim to replicate the index's performance and usually have lower fees.
• Target-Date Funds: Also known as life cycle funds, target-date funds are designed for investors with a specific retirement date in mind. They automatically adjust their asset allocation over time, becoming more conservative as the target date approaches. This makes them a good choice for investors seeking a simple, long-term investment solution.
• Specialty Funds: Specialty funds focus on specific investment strategies or asset classes beyond stocks and bonds. Examples include sector funds, socially responsible investment (SRI) funds, real estate funds, and commodity funds.

When choosing a mutual fund, it's important to consider your investment goals, risk tolerance, time horizon, and financial situation. Different types of mutual funds cater to different investment strategies, so selecting the right type of fund is crucial for aligning with your financial objectives.

Set clear investment goals

Setting clear investment goals is a crucial step in investing in mutual funds. Here are some detailed guidelines to help you set clear and effective investment goals:

• Identify your investment objectives: Start by defining your financial goals and the purpose of investing in mutual funds. Are you saving for retirement, buying a home, funding your child's education, or building wealth over the long term? Clearly understanding your investment objectives will help you choose the right types of mutual funds and create a plan to achieve your goals.
• Determine your time horizon: Consider how long you plan to invest before accessing your funds. This will help you select mutual funds that align with your timeline and ensure you don't face liquidity issues. Generally, an investment horizon of at least five years is ideal to mitigate the impact of sales charges and fees.
• Assess your risk tolerance: Evaluate your willingness to take on financial risk. Are you comfortable with higher volatility and potential losses in pursuit of higher returns, or do you prefer a more conservative approach with lower risk? Understanding your risk tolerance will guide you in choosing the right types of mutual funds, such as growth funds or income funds.
• Evaluate your financial situation: Analyze your current income, expenses, and debts to determine how much you can realistically afford to invest without compromising your financial stability. This will help you set a realistic budget for your mutual fund investments.
• Choose the right types of mutual funds: Based on your goals, risk tolerance, and financial situation, decide on the types of mutual funds that align with your objectives. Consider whether you prefer actively managed funds that aim to outperform the market or passively managed index funds that track market performance. Additionally, determine the mix of equity funds, bond funds, balanced funds, or other specialty funds that match your risk tolerance and investment strategy.
• Set specific and measurable goals: Define clear and measurable goals for your mutual fund investments. For example, you may set a goal to invest a certain amount each month or quarter, or you may aim for a specific rate of return over a defined period. Clear and measurable goals will help you track your progress and make necessary adjustments.

By following these guidelines and setting clear investment goals, you will be well on your way to successful mutual fund investing. Remember to regularly review and adjust your goals as your financial situation and market conditions evolve.

Research and compare funds

Researching and comparing mutual funds can be more difficult than for other securities. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose the price-to-earnings (P/E) ratio, sales growth, earnings per share (EPS), or other important data. However, there are still several factors you can consider when researching and comparing mutual funds. Here are some key points to keep in mind:

• Fund Type: Different types of mutual funds include equity funds, bond funds, balanced funds, money market funds, index funds, and target-date funds. Each type has its own investment strategy, risk profile, and potential returns. Choose funds that match your investment objectives, such as growth, income, or a combination of both.
• Investment Style: Mutual funds can be actively or passively managed. Actively managed funds aim to beat the market using professional fund managers, while passively managed funds, like index funds, aim to match market performance by tracking a specific index. Actively managed funds typically have higher fees.
• Expense Ratios: Mutual funds charge annual fees, expressed as a percentage of the fund's average net assets, to cover operating expenses. High expense ratios can significantly impact your returns over time, so look for funds with low expense ratios.
• Loads: Some mutual funds charge sales fees, known as "loads," when you buy or sell shares. Front-end loads are charged when you purchase shares, while back-end loads are assessed if you sell your shares before a certain date. No-load funds, or no-transaction-fee funds, do not have these sales commissions.
• Additional Fees: In addition to expense ratios and loads, mutual funds may charge other fees such as redemption fees and 12b-1 fees for marketing and distribution. Compare these fees carefully, as they can vary significantly between funds.
• Minimum Investment: Some mutual funds require a minimum initial investment, which could range from $100 to $1,000 or more. If you are investing through your employer, these minimums may be waived.
• Fund Manager Experience: Consider the track record and experience of the fund manager. Look for managers who have been with the fund for several years, as this may indicate a more stable management approach. Review the manager's biography, investment philosophy, educational background, and previous experience.
• Fund Size: Funds with larger assets under management (AUM) tend to be more established and better equipped to manage the fund effectively. Look for funds with AUM of $100 million or more.
• Liquidity: This refers to the fund's ability to convert its investments into cash to meet redemption requests. Funds with higher liquidity can accommodate investors coming into and out of the fund more easily. Funds that invest primarily in large-cap stocks or high-quality bonds tend to have higher liquidity.
• Tax Implications: If investing in a taxable account, consider the tax efficiency of the fund. Look for funds that minimize turnover and distribute fewer capital gains to reduce the tax impact on your returns.

Remember, there is no one-size-fits-all approach to selecting mutual funds. Your investment goals, risk tolerance, and financial circumstances should guide your decisions. Compare funds based on these factors to find the ones that best align with your needs.

Open an investment account

If you're not acting through your employer, you'll need to open an investment account with a brokerage firm or directly with a mutual fund company to invest in mutual funds. There are a few types of investment accounts that you may be able to choose from:

• Taxable brokerage accounts: These accounts allow you to invest in a wide range of securities, including stocks and bonds, in addition to mutual funds. They can be held as an individual, as a joint account with a spouse or partner, or as a custodial account held on behalf of minor dependents.
• Retirement accounts: 401(k) plans and individual retirement accounts (IRAs) offer tax advantages and are designed for long-term investing. Roth IRAs are a tax-exempt retirement account option where you can put dividend-paying mutual funds without triggering taxable events.
• Education savings accounts: Accounts like 529 plans can help you save for future education expenses.

When opening a new account, you will need to provide personal information such as your name, address, Social Security number, and employment details. You will also need to fund your account by transferring money from your bank account or mailing a cheque.

If you participate in an employer-sponsored retirement plan at work, such as a 401(k) or 403(b), you already have access to mutual funds. Most retirement plans direct your contributions to mutual funds rather than individual stocks or bonds, and you can typically elect to invest in target-date funds if you'd prefer to automate your portfolio management.

If you don't have access to an employer-sponsored retirement account or are investing for a goal outside of retirement, you can invest in mutual funds by opening a brokerage account on your own and investing in the following plans:

• Individual retirement accounts (IRAs): You can invest in mutual funds for retirement via tax-advantaged IRAs.
• Taxable brokerage accounts: Taxable accounts at an online broker lack the tax benefits of 401(k) plans or IRAs, but you can make withdrawals at any time without paying penalties. This makes them well-suited for goals you'd like to achieve before the federal retirement age of 59 1/2.
• Education savings accounts: If you have children and want to save for their college education, you can open a 529 college savings account and invest in mutual funds.

Place orders and make contributions

Once your investment account is set up and funded, you can start investing in mutual funds. You can invest a lump sum or make regular contributions over time, perhaps directly from your paycheck. Lump-sum investing involves investing a significant amount of money at once, which can be advantageous if you believe the market will rise. However, this approach also exposes you to greater market risk.

Another strategy is dollar-cost averaging, which involves investing a fixed amount of money at regular intervals, regardless of market conditions. This approach can help mitigate the impact of market volatility on your investments, as you buy more shares when prices are low and fewer shares when prices are high.

To place an order, log into your investment account and select the mutual fund you wish to buy. Specify the amount you want to invest and submit your order. Mutual fund orders are typically processed at the end of each trading day, with the price per share determined by the fund's net asset value (NAV) at the close of the market.

The process for selling your mutual fund shares is similar. You place a sell order with the fund company or brokerage firm, and the order is executed at the next available NAV. The proceeds from the sale, minus any applicable fees or taxes, are then credited to your account.

Frequently asked questions