Mutual funds allow you to buy a share of a basket of equities, so you can purchase multiple investments at once.
Mutual funds do this by pooling the money of multiple investors to buy a strategic group of investments. This might be a group of stocks, bonds or other types of securities, grouped together by industry, size of company or by mimicking a market index. Mutual funds make it easier for investors to diversify and invest for the future — here’s how to do it.
- Step 1: Determine your investing goals and objectives
- Step 2: Understand active vs. passive mutual funds
- Step 3: Diversify your mutual fund investments
- Step 4: Watch out for mutual fund fees
- Step 5: Manage your mutual fund investments
- Should you get help investing in mutual funds?
Step 1: Determine your investing goals and objectives
First, you’ll want to figure out what you plan to do with the money you’re investing. Is it for retirement? College? A down payment on a house?
Answering this question will help inform the types of mutual funds you would consider. For instance, if you’re saving money for a down payment on a home, you probably wouldn’t invest it in a target-date retirement fund. (That would be a better strategy for your retirement savings.)
Risk tolerance is also important to consider. This is essentially how comfortable you are with big swings in the value of your investment.
“Knowing the client’s risk tolerance level will help determine the level of risk acceptable, along with time horizon and funding level,” said Thomas Rindahl, a certified financial planner based out of Phoenix. “For example, if a client needs $1 million at retirement and has 20 years, a more risk tolerant investor would need to set aside less each year than someone who is more conservative in nature.”
Here are some questions to ask yourself:
- When do you need the money?
- What do you hope to do with the money later?
- How comfortable are you taking risk with this money?
- How much do you hope to earn on your investment?
- How much are you able to save each month or each year?
If you’re saving for retirement, consider calculating how much you expect to need annually in retirement, and then multiply that number by 25 (assuming 25 years of retirement). Fidelity offers other guidelines, which suggest trying to save the following:
- 1x your annual salary saved by age 30
- 3x your annual salary saved by age 40
- 6x your annual salary by age 50
- 8x your annual salary by age 60
Step 2: Understand active vs. passive mutual funds
When it comes to mutual fund investing, you’ll have to decide whether you’re trying to beat the market — which is hard — or simply match it. Your goals will affect your overall mutual fund strategy when deciding between actively managed versus passively managed funds.
Investing in actively managed mutual funds
Actively managed mutual funds are just that — actively managed. That means a manager or a team of people work to put together a group of investments that they’re betting will outperform the market.
Statistically, this often isn’t successful — the majority of actively managed funds lag behind the market over time, according to research from S&P Global. Additionally, actively managed funds tend to come with higher fees.
Investing in passively managed mutual funds
With passively managed funds, you’re essentially letting computer models do the work. Passively managed funds are often modeled after a representative index. A fund based on the S&P 500 index, for example, would be designed to mimic the performance of the S&P 500 — so if that index goes up by 7% in a year, so would your investment fund, minus any fund expenses.
Fees are typically lower with passively managed mutual funds because they involve less monitoring and effort. There’s also evidence they often outperform actively managed funds.
Step 3: Diversify your mutual fund investments
As with all investing, you don’t want to put all your eggs in one asset basket, so to speak. While it’s acceptable to own funds with a specific focus — technology stocks, for instance, or high-yield bonds — it’s not smart to put all your money into a single area of the market.
“You can make as many guesses as you want, but we simply don’t know what is going to perform well in any upcoming year and what’s going to perform poorly,” said Ted Toal, a financial planner based out of Baltimore. “It’s best to generally own everything so you don’t have to guess. In the long run, you should come out with the average return of the market.”
The idea behind diversification is that you put your money into different kinds of assets, such as U.S. large companies, U.S. small companies, international stocks, bonds, real estate and commodities. Your asset allocation — what percentage of your portfolio you invest in each type of asset — depends on your risk tolerance, time horizon and goals. Investors who are closer to retirement, for instance, might have more of their money in conservative investments like bonds, but younger investors might invest in a higher percentage in stocks.
Some types of mutual funds you might consider investing in include:
- Small cap:Small-cap mutual funds are made up of companies with a smaller market value — generally $300 million to $2 billion. Small-cap companies are considered a riskier bet — they can fail and take your investment with them — but they can also return significant gains because there’s a lot of room for growth.
- Large cap: Large-cap funds, on the other hand, are invested in companies with a bigger market value, usually more than $10 billion. Large-cap funds are considered more stable, but there’s also less potential for sky-high earnings.
- Income: Mutual funds that focus on income are invested in companies that produce more cash flow for investors in the form of dividends or interest.
- Growth: Growth mutual funds include companies that are generally increasing in price compared with their earnings. “The investors’ hope is that the earnings will keep up with the current and future price movement,” Rindahl said.
- International: International mutual funds, as you might expect, are funds that are invested in companies outside your home country. These might be developed countries or emerging markets, and some funds focus on a specific region.
When choosing funds, remember not to chase returns. You can look at how a fund has done in the past, but don’t make your decision based solely on track record.
“Good past performance could be luck or a skill set that was trending at the right time at the right place,” said Mitchell Kraus, a financial planner based out of Santa Monica, Calif. “It’s very easy to create a portfolio or find funds that have great past performance. The trick is finding funds that will perform well moving into the future.”
If you’re determined to use track record as a metric, compare a mutual fund’s history to that of its peers. “Too many clients will see a fund that went up and buy into it, and most of that return was based on being in an asset category that had done well,” Kraus said. “There are funds that underperformed the market as a whole but have overperformed their peers in their asset category, and those are the funds that are important to look for moving forward.”
Where to buy mutual funds
As for where you can actually buy mutual funds, you have a few options to consider. For starters, you can invest in mutual funds through your employer-sponsored retirement plan, such as a 401(k).
Other options including buying directly from the company that created the fund, such as Vanguard’s collection of mutual funds, or going through a brokerage. When choosing a broker, you’ll want to consider the selection of funds available, the user-friendliness of the platform and the costs involved, which we will discuss in more detail below.
Also keep in mind that some mutual fund providers have minimum investment requirements, which will dictate how much you’ll need to invest to get started. While some brokers have no minimum, others can have minimums ranging from $500 to $3,000 or more.
Step 4: Watch out for mutual fund fees
One of the biggest factors affecting your returns is the cost of your investments. For every 1% you’re paying in fees, for instance, that’s 1% less you’re taking home in earnings each year.
Here are some fees in particular to look out for:
- Expense ratios: A mutual fund’s expense ratio represents the annual operating costs of running the fund. The lower the expense ratio, the more you’ll take away in earnings. “If you own a fund where the gross return was 10% during the year and the expense ratio was 2%, then you are only netting 8%,” Toal said. “And studies have shown that funds with lower expense ratios tend to have better performance over time than funds with higher expenses.”
- Transaction fees: Some mutual funds carry transaction fees. These include sales charges, or loads, which you might pay when you purchase or sell a mutual fund, or early redemption fees, which you’d pay if you sell a fund within a specified early redemption period. Mutual funds without sales fees are called no-load funds.
All things being equal, you’re better off choosing no-load mutual funds if you can. The less you pay on the front end, the more you’ll have available to invest overall. There are a number of quality no-load funds available to choose from.
Step 5: Manage your mutual fund investments
There’s no need to monitor your mutual funds daily, but investments also aren’t a set-and-forget situation. You’ll want to check your investments on a regular basis and rebalance when your asset allocation drifts too far from your target percentages.
For instance, if your original portfolio was 70% stocks and 30% bonds, and at the 12-month mark your mix is at 63% stocks and 37% bonds, you would sell some bonds and buy some stocks to return your portfolio to its original target balances.
Experts recommend rebalancing about once a year, though it’s ultimately based on personal preference. Rebalancing more often can decrease your portfolio’s volatility.
Should you get help investing in mutual funds?
Whether you should consider seeking out professional guidance for your mutual fund investing depends on your goals and your comfort with making investing decisions. If you’re happy managing your own investment mix, it’s feasible to DIY your portfolio. At the simplest level, you could choose a target date retirement fund, which automatically diversifies your portfolio based on (you guessed it) your target retirement year, shifting your money into a more conservative mix as you get closer to retirement age.
If you’re an investor who needs a little guidance — or who might sell all your investments in a panic if the market dips — a financial advisor may be a good addition to your team. If nothing else, they can help you make decisions about your money during or after big life changes or when there’s significant market turmoil.
Mutual fund investing can be a little overwhelming. There are thousands of funds available, you’ve got limited time to research them and everyone has an opinion about where you should put your money. But if you’ve done your due diligence, are investing regularly and are diversified, you probably will be in good shape. Just make sure to stick with your plan.
“With all the information available today, it’s easy to get distracted and think there’s something better out there,” Toal said. “What most people will find is by constantly moving your money, usually you’re going to earn much less over time than if you just pick a good fund, stick with it and keep putting money into it.”