Mutual Funds: Smart Ways To Invest Small Amounts

Mutual funds are a great way to build a diversified portfolio without a lot of extra cost or hassle. They are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional money managers and allow individual investors to gain exposure to a professionally managed portfolio.

Mutual funds are a good option for both beginners and experienced investors as they benefit from diversification and the former can also gain from the former's professional management. However, it is important to remember that mutual funds are not a guaranteed way to get rich quickly. They are a long-term investment option and diversification is inherent in them, meaning that by investing in one, you spread the risk across a number of companies or industries.

There are two types of mutual funds: active and passive. Active funds are managed by professionals with the goal of outperforming a market index and usually come with larger fees. Passive funds, on the other hand, are managed to track the performance of a market index and usually charge very low or no fees.

When investing in mutual funds, it is important to consider the fees associated with them as these costs will significantly affect your investment returns over time. You should also be aware of the different types of mutual funds available, such as stock, bond, money market, index, and target-date funds, and choose the ones that align with your financial goals and risk tolerance.

To invest in mutual funds, you need to open an investment account, decide on your budget, and choose a brokerage account. You can then purchase shares of the desired mutual funds, set up a plan to invest regularly, and consider your exit strategy when it is time to sell.

Understand the different types of mutual funds

There are several types of mutual funds, and they can be confusing to navigate. Here is a look at some of the more popular types of funds.

Stock or Equity Mutual Funds

These funds invest in corporate stocks but can also pursue different strategies from fund to fund. Some funds focus on companies that pay dividends and are well-established, while others are more focused on growth and the potential for price appreciation. Still, others are focused on specific industries, sectors, or geographies. Stock mutual funds carry the highest potential rewards but also higher inherent risks.

Bond Mutual Funds

These funds invest in various forms of debt, and their risk profiles can vary widely from fund to fund. Some will invest in relatively safe bonds issued by governments, while others invest in so-called "junk" bonds that offer higher potential returns. Be sure to read the prospectus before investing to make sure you understand the risks being taken. Bond mutual funds provide a more stable rate of return than stock funds, and as a result, potential average returns are lower.

Money Market Mutual Funds

These funds tend to be low-risk and earn a small return above that of a normal savings account. Money market funds invest in high-quality short-term debt issued by companies and governments.

Index Mutual Funds

Index funds have surged in popularity in recent years due to their simplicity and low-cost structure. They track the performance of an index such as the S&P 500 and are usually able to keep costs low. Studies have shown that this passive approach outperforms active management over long time periods in most cases.

Research and compare funds

Researching and comparing funds is an important step in the process of investing in mutual funds. Here are some key considerations to keep in mind:

• Past Performance: While not a guarantee of future success, evaluating a fund's historical performance can provide insights into how well it has met its stated goals. Compare its performance to similar mutual funds or benchmark indices.
• Expense Ratios: These are annual fees that cover the fund's management and operational costs. The industry average is around 0.57%, but some funds charge significantly less. Keep in mind that higher expense ratios can impact your investment returns over time.
• Load Fees: Load fees are sales commissions charged by brokers when buying or selling mutual fund shares. Try to avoid these fees if possible, as they can eat into your returns. "No-load" funds, on the other hand, do not charge these commissions.
• Management: Actively managed funds aim to outperform an underlying index through strategic investment decisions, but they usually come with higher fees. Passively managed funds, or index funds, aim to replicate the performance of an index and typically have lower fees. Historically, passively managed index funds have outperformed their active counterparts over the long term.
• Investment Strategy: Understand the fund's investment strategy and whether it aligns with your goals. Some funds focus on growth and price appreciation, while others emphasize dividend-paying stocks or specific sectors. Be sure to read the fund prospectus to grasp the risks and investment approach.
• Diversification: Mutual funds offer instant diversification by pooling your money with other investors to purchase a wide range of securities. This diversification can help spread risk and enhance your investment portfolio.
• Fees and Commissions: Be mindful of the various fees and commissions associated with mutual funds. Management fees, 12b-1 fees (covering marketing and selling expenses), and other administrative costs can impact your returns. Additionally, some funds charge load fees or commissions during the purchase or sale of shares. No-load funds, on the other hand, do not have these commissions.
• Tax Implications: Consider the tax implications of investing in mutual funds, especially if you plan to hold them in a taxable account. Capital gains taxes may apply when you sell appreciated funds. To mitigate this, consider holding mutual funds in tax-advantaged accounts like IRAs, where tax-free growth is possible.

When researching and comparing mutual funds, utilize tools like the Mutual Fund Observer and Maxfunds, as well as the research and screening tools provided by brokerages. Remember to evaluate funds based on your financial goals, risk tolerance, and investment horizon.

Decide on an investment account

If you're already contributing to an employer-sponsored retirement plan, 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 particularly well-suited for goals you'd like to achieve before 59 1/2, the federal retirement age.
• 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.

When deciding where to buy mutual funds, you'll want to consider:

• Affordability. Mutual fund investors can face two kinds of fees: from their brokerage account (transaction fees) and from the funds themselves (expense ratios and front- and back-end "sales loads").
• Fund choices. Workplace retirement plans may carry only a dozen or so mutual funds. You may want more variety than that. Some brokers offer hundreds, even thousands, of no-transaction-fee funds to choose from, as well as other types of funds like ETFs.
• Research and educational tools. With more choice comes the need for more thinking and research. It's vital to pick a broker that helps you learn more about a fund before investing your money.
• Ease of use. A brokerage's website or app won't be helpful if you can't make heads or tails of it. You want to understand and feel comfortable with the experience.

You can buy mutual funds directly from the company that created the fund, such as Vanguard or BlackRock, but doing so will limit your choice of funds. You can also work with a traditional financial advisor to purchase funds, but it may incur some additional fees.

Most investors opt to buy mutual funds through an online brokerage, many of which offer a broad selection of funds across a range of fund companies.

Calculate your budget

When calculating your budget for investing in mutual funds, there are a few things to consider. Firstly, you need to be aware of the cost of mutual funds. While some funds have minimum investment amounts ranging from $500 to $3,000, there are also funds with minimums as low as $100 or even $0. It's important to choose a fund that aligns with your financial capabilities.

Another aspect to consider is how much money you are comfortable investing. You should assess your financial situation and determine an amount that you can comfortably invest without straining your budget. This will help ensure that you don't overextend yourself and that you have enough funds to cover your other expenses and financial goals.

Additionally, when deciding on your budget, you should research the different types of mutual funds available and select the ones that align with your investment goals and risk tolerance. For example, if you are a beginner investor, you might want to consider investing in a low-cost S&P 500 index fund. On the other hand, if you are a more experienced investor, you may want to consider actively managed funds that target specific areas you believe will perform well.

It's important to keep in mind that investing in mutual funds comes with certain fees, such as management fees, transaction fees, and expense ratios. These fees can impact your overall returns, so be sure to factor them into your budget calculations. By carefully considering the cost of mutual funds, your financial situation, and your investment goals, you can determine a budget that aligns with your needs and helps you achieve your financial objectives.

Understand the fees

Fees are an important consideration when investing in mutual funds, as they will significantly affect your investment returns over time. Here are some common types of fees associated with mutual funds:

Expense Ratio

The expense ratio is an annual fee that covers the fund's operating expenses, including management fees, administrative costs, and marketing expenses. It is expressed as a percentage of the fund's average net assets and is deducted from the fund's returns. For example, a fund with a 1% expense ratio will cost you $10 for every $1,000 invested. Over time, these fees can significantly impact your investment returns, so it is important to pay attention to them.

Sales Charges or 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, or contingent deferred sales charges, are assessed if you sell your shares before a certain date. No-load mutual funds, on the other hand, do not have any commission or sales charges.

Redemption Fees

Some mutual funds charge a redemption fee when you sell your shares within a short period (usually 30 to 180 days after purchasing them.) This fee is typically limited to 2% and is designed to discourage short-term trading in these funds to maintain stability.

Other Account Fees

Some funds or brokerage firms may charge additional fees for maintaining your account or transactions, especially if your account balance falls below a certain minimum. These fees can include maintenance fees, transaction fees, or account closure fees.

Management Fees

Management fees are paid to the fund's managers and investment advisors for their services in managing the fund's portfolio. These fees are included in the expense ratio but are worth noting as they can be a significant portion of the overall fees.

12b-1 Fees

These fees cover the costs of marketing and selling the fund, and are also included in the expense ratio. 12b-1 fees are typically charged by funds that have higher sales and distribution costs, such as those that are actively promoted and sold by brokers.

Load Fees

Load fees are sales commissions charged by the broker who sells you the mutual fund. Mutual funds are often classified as "load" or "no-load" funds, with load funds charging commissions and no-load funds charging none. Load fees can impact your investment returns, so it is generally advisable to avoid paying them if possible.

Understanding the Impact of Fees

It is important to carefully consider the fees associated with mutual funds, as they can significantly impact your investment returns over time. Even a small percentage fee can add up to a substantial amount over the long term. Additionally, fees can vary widely between different funds, so it is worth shopping around and comparing fees before making an investment decision. By understanding and comparing the fees charged by different funds, you can make more informed investment choices and maximize your investment returns.

Frequently asked questions