Shares in mutual fund investors are shares in companies whose business involves buying shares or bonds from other companies. Although mutual fund investors do not directly own stock in the companies they purchase, they share equally in the profits and losses of all fund holdings. This is why mutual funds are called “mutual”. This information helps if you invest in mutual funds.
What is a mutual fund?
Mutual funds are investments that pool money from investors to buy stocks, bonds, and other assets. Mutual funds aim to provide a more diverse portfolio than an average investor can on their own. Professional fund managers can buy your securities on behalf of mutual funds.
Active vs. passive mutual funds
The fees and performance of a mutual fund will vary depending on whether it is managed actively or passively.
Passively managed funds are designed to match a particular benchmark. They aim to match the performance a specific market index, such as the S&P 500. Therefore, they don’t usually require professional management. This means that passive mutual funds typically have lower overhead than actively managed funds.
These are two popular types of mutual funds for passive investing.
1. Index funds consist of stocks and bonds that are listed on one index. The risk is intended to reflect the return of the index. If the S&P 500 index funds are up 3% per day and you also own one of these index funds, your index fund should be about the same.
2.Although exchange-traded funds are able to be traded like individual stocks, they offer diversification benefits and the flexibility of mutual funds. ETFs are more affordable than index funds in many cases.
An active manager fund has a professional manager or a team of managers making investment decisions. Often, they try to outperform the market or a benchmark index, but studies have shown passive investing strategies often deliver better returns.
Mutual fund types
Mutual funds can be divided into different categories beyond passive and active designations. While some mutual funds invest only in stocks and bonds, others may be more focused on investing in multiple asset classes. These are the major types of mutual funds.
- Stock (equity funds) typically have the highest risk and the highest potential returns. Stock market fluctuations can have a dramatic impact on the returns of equity funds. There are many types of equity funds: income funds, growth funds, and sector funds. Each group tries to keep a portfolio of stocks that has certain characteristics.
- Fixed-income (or bond) funds are generally less risky than stock funds. There are many types of bonds. You should investigate each mutual fund separately to determine how much risk it carries.
- Balanced funds invest in a mixture of stocks, bonds, and other securities. Asset allocation funds, also known as hybrid funds or asset allocation funds, are a “fund” that invests in a variety of stocks, bonds, and other securities. A target-date fund is one popular example. It automatically selects and reallocates assets towards safer investments as you approach retirement.
- Because they are less risky, money market funds can have the lowest returns. Money market funds must legally invest in short-term high-quality investments issued by the U.S. government.
How mutual funds make you money
Your investment in a mutual fund can grow in three ways.
1. Dividend payments: A fund distributes a portion of the income it receives from its portfolio by paying dividends or interest. You have the option of receiving your dividends directly or having them reinvested into the mutual fund.
2. Capital gains: A capital gain is when a fund sells a security that has increased in price. A capital loss is when a fund sells a security that has fallen in price. Most funds distribute net capital gains annually to investors.
3. Net asset value: After the market closes, mutual fund shares can be purchased. This is when the entire financial worth of the underlying assets is valued. The mutual fund share price is also known as the net asset value (or NAV). The NAV per share, or the fund’s value, is the price at which you can purchase mutual fund shares. This is similar to the situation when a stock price rises. While you won’t get immediate distributions, the value of your investment increases and you could make money if you decided to sell.
Can you lose money in mutual funds?
Mutual funds are risky investments. You could lose your money. Mutual funds often offer the diversification, which means that you can spread the risk among a variety of industries or companies by investing in one. However, investing in individual stocks and other investments can carry higher risks.
Your investments’ value will only increase if you have enough time. You may not be able to weather the inevitable market peaks and valleys to reach again if you have to withdraw your cash within five years. If your money is needed in less than two years, and the market falls, you might have to withdraw it at a loss. Mutual funds, especially equity mutual funds, should be considered long-term investments.
How to invest in mutual funds
Here’s our step-by-step guide to buying mutual funds if you are ready to make an investment.
1. Decide whether to go active or passive
The first decision is probably the most important: Do you won’t beat the market or do you want to try to copy it? It’s also an easy decision: Each approach is more expensive than the other and often doesn’t deliver better results.
Professionals who study the market and manage active funds buy with an eye to beat it. Although some fund managers may be able to achieve this short-term, it is difficult to beat the market long-term and on a consistent basis.
Passive investing, which is more hands-off, is growing in popularity due to its ease and potential for great results. Passive investing is often less expensive than active investing.
2. Calculate your budget
How much do mutual funds cost? The best thing about mutual funds? You can choose how much you want to invest once you have met the minimum investment amount. Although mutual fund minimums can range from $500 to $3,000 (some are in the $100-$3,000 range), others are lower than that and some have a $0 minimum.
If you choose a fund that has a $100 minimum and invest the amount, you might be able to decide how much or little you wish to contribute. You could invest as little as $1 in a mutual fund if you choose a fund that has a minimum of $0
Apart from the initial investment, determine how much you can comfortably invest. Then choose an amount.
What mutual funds are best to invest in? You might have decided to invest in mutual fund funds. What initial fund mix is best for you?
The closer you get to retirement, the more conservative investments you should have. Younger investors have more time to protect themselves from market downturns and riskier assets. Target-date mutual funds take the guesswork out the “what’s your mix?” question. These funds automatically reallocate assets as you age.
3. Decide where to buy mutual funds
While you need a brokerage account to invest in stocks, there are many options for mutual funds. There’s a good possibility that mutual funds are already in your employer-sponsored retirement account (e.g. a 401(k).
However, you can also buy directly from the company creating the fund (e.g. Vanguard or BlackRock), but this may limit your options for funds.
Many online brokerages offer an extensive selection of mutual funds from a variety of fund companies. This is the preferred way for investors to purchase mutual funds. You should consider the following:
- Affordability. Two types of fees can be charged to mutual fund investors: transaction fees from their brokerage account (transaction fee) and the funds themselves (expenses ratios and sales loads at both fronts- and back-end). These fees are more detailed below.
- Fund choices. Some workplace retirement plans only have a handful of mutual funds. There may be more options. There are hundreds of funds that you can choose from without transaction fees, some even thousands.
- Research and educational tools. There are many options, but you need to think and research. Before you invest your money, it is important to find a broker who can help you understand the fund.
- Ease of use. If you don’t understand the app or website of a brokerage, it won’t be very helpful. It is important to feel at ease and understand the process.
4. Understand mutual fund fees
Whether you choose active or passive funds, a company will charge an annual fee for fund management and other costs of running the fund, expressed as a percentage of the cash you invest and known as the expense ratio. A fund with an expense ratio of 1% will cost you $10 per $1,000.
It can be difficult to determine a fund’s expense ratio upfront. You may need to go through the prospectus of the fund to find it. However, it is well worth the effort. These fees can reduce your returns over time.
There are many structures for mutual funds that can have an impact on costs.
- Open-end funds: This is the most common type of mutual fund. There are no restrictions on how many investors can invest or how many shares they can hold. The fund’s value affects the NAV per share.
- Closed-end funds: The funds offer a smaller number of shares than a company’s initial public offering. There are far fewer closed-end funds on the market compared with open-end funds. The trading price of a closed-end fund is listed on a stock exchange throughout the day. This price can be either higher or lower than its actual value.
The “loads” that indicate whether funds are subject to commissions include:
- Load funds: A commission or sales charge is paid to a broker who sold mutual funds. This commission is usually passed to the investor.
- No-load funds: These mutual funds are also known as “no-transaction-fee funds” and charge no sales commissions when a fund share is purchased or sold. This is the best deal possible for investors. Brokers such as TD Ameritrade or E*TRADE offer thousands of options for mutual funds that are free from transaction fees.
5. Manage your portfolio
After you have decided on the mutual funds that you wish to purchase, it’s time to start thinking about how you will manage your investment.
A good idea is to rebalance your portfolio at least once per year with the aim of maintaining your diversification plan. If one of your investments has made great gains, and it now makes up a larger percentage of your portfolio, you might think about selling some of those gains to invest in another slice.
You can avoid chasing performance by sticking to your plan. Fund investors (or stock pickers) are at risk if they want to invest in a fund after seeing how it performed last year. It is a common investing cliché that “past performance does not guarantee future performance”. This doesn’t mean that you should stay in one fund your whole life. However, chasing performance is almost always a losing proposition.
Mutual fund pros and cons
Are you still trying to decide whether mutual funds are right for you? These are the pros and cons of mutual funds.
These are the main benefits of investing in mutual funds.
- Simplicity. You have very little role once you find a mutual fund with a strong track record. Let the managers (or benchmark indexes, in the case of index funds) do the heavy lifting.
- Professional management. The fund’s goals are the basis for the decisions made by active fund managers about buying and selling securities. A manager may try to get higher returns in a fund that has high growth goals, for example. A bond fund manager, on the other hand, seeks to achieve the best returns while taking the least risk. Mutual funds are a great option for professional management if you’re willing to invest the money.
- Affordability. Many mutual funds have a minimum investment of $500 to $3,000. However, many brokers can offer funds that have lower minimums or none at all.
- Liquidity. Mutual funds are more affordable than other assets such as your home or car. They can also be sold easily.
- Diversification. This is one of the most important principles in investing. You can lose your money if a single company goes under. Your loss will be limited if only one mutual fund company fails. Mutual funds allow you to have diversified investments without having to manage dozens of assets.
Here are some major cons of mutual funds:
Fees. The downside to mutual funds is the fact that fees will be charged regardless of how well they perform. These fees are lower for passively managed funds than active funds.
Lack of control. It is possible that you don’t know the fund’s exact composition and are not able to make decisions about its purchases. This can be a relief for investors who don’t have enough time to manage large portfolios.