New investors have several investment options to choose from. Although investing in stocks may seem like the most popular choice, learning how to invest in mutual funds is an alternative that new investors might want to consider.
Mutual funds can potentially offer many benefits to help new investors. Compared with completing an in-depth analysis on several stocks, you can learn how mutual funds work and pick a suitable mutual fund relatively quickly. Here’s what you should know about mutual funds to help you decide whether they’re right for your investment portfolio.
What is a mutual fund?
A mutual fund combines the money of many investors and invests it in assets that help meet the fund’s investment goals. There are thousands of mutual funds to choose from, and each invests in a variety of assets. For instance, one fund may invest in all companies in the Dow Jones Industrial Average. Alternatively, a mutual fund may focus on a specific type of company, such as oil producers.
No matter which type of mutual fund you choose, each diversifies its holdings by investing in several different investments within the fund’s scope. This can help reduce the risk of a single investment failing and taking your entire balance with it. During volatile markets when prices increase or decrease rapidly, this diversification might give you peace of mind. On the flip side, it could also reduce the chance that a home-run investment turns you into an overnight millionaire.
Each fund may invest in different assets or use different approaches. Actively managed mutual funds try to provide returns that beat the markets. Although this concept sounds appealing, these funds typically cost more to invest in and may not always accomplish their goal of higher returns.
Investors looking for a lower-cost and more predictable investment may prefer passively managed mutual funds. These funds aim to match the returns of an established index of investments, such as the S&P 500. They don’t actively trade to try to eke out higher returns.
Types of mutual funds
Besides actively and passively managed mutual funds, there are several additional types to choose from.
Money market funds
Current laws limit money market funds to investing in specific investment types. These investments typically don’t provide high returns but provide an alternative to keeping your money in a checking account that doesn’t earn interest. Even so, money market mutual funds can technically lose money.
Bond funds invest in debt instruments called bonds. Bonds get issued by companies and governments to raise funds. Then, the bond issuer pays the bondholder (which is the mutual fund in this case) interest payments. Eventually, the bond issuer repays the bond amount in full plus the interest cost associated with it.
These investments are often considered safer than stock investments because bondholders have priority over stockholders in bankruptcy proceedings. As such, the return on bonds funds is normally lower than the return on similar stock funds.
Stock funds come in many different types depending on the stocks the mutual fund decides to invest in. Each fund type has its own risks and rewards.
Some stock funds are index funds that focus on tracking a stock index, such as the NASDAQ. Others choose specific categories of companies. One fund may invest in stocks focused on rapid growth potential. Another may decide to invest conservatively in utility companies that tend to pay increasing dividends.
Target-date funds aim to fit your investment needs for your entire investment time horizon, making saving for retirement easier. These funds usually have a year associated with them. The idea is you pick a fund closest to the year you want to retire and the asset allocation is adjusted over time.
Initially, these funds start aggressively with more stock funds to help investment growth. As you get closer to retirement, they typically rebalance to reduce your holdings in stock funds and increase holdings in more conservative assets, such as bond funds. Once you retire, the fund focuses on providing retirement income.
Why invest in a mutual fund?
Mutual fund investing may be attractive to different people for varying reasons.
Mutual funds typically handle diversification for you. They generally invest in a wide variety of investments that meet the mutual fund’s goal. The instant diversification mutual funds provide can allow you to focus on other parts of your finances, such as finding more money to invest.
You need to be careful of overlap in investments if you invest in several mutual funds, though. Each mutual fund discloses exactly what it invests in within its prospectus document. You may think you’re diversified by holding several mutual funds when they actually invest large portions of their holdings in similar investments.
Growth potential from a professional fund manager
Investment professionals manage each mutual fund. If you opt to invest in index mutual funds, fund managers will simply try to align investments with a particular index, such as the S&P 500.
Investors that are interested in trying to beat the stock market’s returns may also choose to invest in an actively managed mutual fund. In these instances, it’s important to carefully consider the professional money manager who runs the fund. The money manager chooses the investments and, by doing so, could directly impact the returns the fund provides.
A wide selection of investment options
According to Statista, a market and consumer data company, almost 8,000 mutual funds existed in 2019. Each fund has unique investment objectives, money managers, and fees. If you’re interested in investing in mutual funds, chances are you can find at least a handful that meet your needs while keeping costs low.
What to consider before you invest in a mutual fund
It’s important to consider several factors before you start investing in mutual funds. First, you must make sure you have enough cash set aside to meet the fund’s minimum initial investment requirement. Minimum investments could be as low as $0 or require thousands of dollars, depending on the fund.
When investigating funds, pay close attention to the expense ratios, an annual fee expressed as a percentage, and other fund fees. Load fees, in particular, are important to research. These are charges to buy (a front-end load) or sell (a back-end load) a mutual fund. Most mutual funds today are no-load funds, but load funds still exist. If everything else is equal, a fund with a lower expense ratio and no load fees helps you keep more of your money invested.
You also have to choose whether you prefer to invest in actively or passively managed mutual funds. Actively managed funds attempt to beat the market. Typically, they come with higher fees than passively managed funds, and there’s no guarantee that an actively managed mutual fund will accomplish its goal of higher returns.
Don’t forget to consider the types of funds you want to invest in. Even within passively or actively managed funds, you have many options to choose from. You may decide to invest in socially responsible companies or a sector you believe has the highest potential for future returns.
And finally, you shouldn’t ignore the tax impacts of investing in a mutual fund. Look at the types of distributions each fund typically makes. These could represent taxable income unless you invest using a tax-advantaged account.
How to start investing in mutual funds
Investing in mutual funds doesn’t have to be complicated. In fact, you might already be investing in mutual funds and not realize it. Employer-sponsored 401(k) plans and other retirement plans often offer mutual funds as investment options.
You can also invest in mutual funds outside of a workplace retirement plan. The best brokerage accounts often offer the ability to invest in mutual funds. Your brokerage firm may allow you to invest using a traditional taxable brokerage account or retirement account options like a Roth IRA. Traditional brokerage firms, such as TD Ameritrade and E-Trade, tend to offer mutual funds, whereas even some of the best investment apps, such as Robinhood and Webull, might not.
When choosing a brokerage firm, it’s important to understand the fees associated with mutual fund investments. Brokerage firms may let you invest in some of their mutual funds for free but charge transaction fees to invest in mutual funds from other companies. For instance, Fidelity allows you to invest in many Fidelity funds without a transaction fee but charges a transaction fee to buy Vanguard’s Total Market Stock Index Fund. If a particular brokerage firm’s funds stand out to you, buying directly through that brokerage firm could be the cheapest option.
Alternatives to mutual funds
Mutual funds provide many investment options, but other investment types may fit your needs better depending on your circumstances.
Exchange-traded funds (ETFs)
Exchange-traded funds work much as mutual funds do. Both offer the option to invest in a basket of securities. However, ETFs can offer more flexibility by letting you trade them throughout the day rather than the one time per day you can trade mutual funds. As a bonus, ETFs often come with lower expense ratios than mutual funds, which could allow you to keep more of your money invested.
Individual company stocks
Although mutual funds typically invest in several individual company stocks, it’s possible that you may want more control over your investments. Directly investing in individual companies by buying shares of stock can give you this control over your assets.
Investing in individual company stocks used to be a costly endeavor due to trade fees. However, many brokerage firms now offer commission-free trades, which can make investing in individual stocks more cost-effective.
Investing in companies or debt is more than enough for many investors. That said, some want exposure to other alternative investments. Popular alternative investments include cryptocurrencies, such as bitcoin or dogecoin, commodities, such as corn or oil, and precious metals, such as silver or gold.
Is investing in mutual funds a good idea?
Investing is a personal decision based on your goals and risk tolerance. If a mutual fund meets your investment objectives and you feel it’s the best option to accomplish your financial goals, then it may be a good idea. Make sure you investigate other options to see whether another alternative may provide greater returns or lower costs at a similar level of risk before choosing an investment product. And remember that past performance is not a guarantee of future results.
How can you research mutual fund performance?
You can research mutual funds by reading their prospectus, a document detailing what the mutual fund invests in, how management runs the fund, and its goals. You can also view historical performance data on many websites by searching the fund’s ticker symbol and read what analysts have to say about a specific mutual fund to help guide your decision.
Morningstar, a financial services firm, makes mutual fund research easy by compiling data about a fund on an easy-to-read page. If you pay for its premium service, you get access to even more data and an analysis of each fund’s investment strategy.
People who prefer to have a professional to research investments on their behalf may want to enlist the services of a fiduciary financial advisor. These professionals must make investment decisions based on your best interests.
What's the minimum amount to invest in a mutual fund?
Each mutual fund sets its minimum amount needed to invest in the fund. Some low-cost funds, such as the four Fidelity ZERO funds, require no minimum initial investment. Others may require $1,000, $3,000, or more to start investing in them.
The bottom line
Investing money in mutual funds gives you plenty of options for instant diversification. With nearly 8,000 mutual funds to choose from, you should be able to find at least a handful that could help you meet your investing goals.
You may be able to get started investing in a mutual fund almost immediately if you have access to a workplace retirement plan. If you don’t, you can learn how to invest in mutual funds on your own. After you pick a mutual fund you want to invest in, find a brokerage firm that allows you to trade that mutual fund while incurring the least amount of fees possible.