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Banking Basics

What Is a Mutual Fund and How to Invest

Mutual funds can be a great investment strategy for new investors. Find out how mutual funds work and what your options are when it comes to investing.

Katana Dumont • June 29, 2022

In This Article

  1. What Is a Mutual Fund?
  2. How Do Mutual Funds Work?
  3. Mutual Fund Investments
  4. Are Mutual Funds a Good Investment?
  5. FAQs
  6. Final Thoughts

Are you looking for a fairly simple and affordable way to get into investing?

If the answer is yes, then you should consider investing in mutual funds. Mutual funds allow you to invest in a portfolio of stocks, bonds, and other securities with a single transaction. They are also managed by professionals, making them perfect for new investors.

Here’s everything you need to know about mutual funds and how to invest in them.

What Is a Mutual Fund?

A mutual fund is a type of investment strategy made of a pool of money collected from many investors to invest in a variety of securities. Securities can range from stocks, bonds, money market instruments, and other assets. Mutual funds are used as a way to diversify your investment portfolio by investing in a basket of assets.

Mutual funds are operated by professional portfolio managers, who use research to decide how best to allocate funds to procure capital gains. Because mutual funds are professionally managed, they are often thought of as a simple way to get into investing — as they take the guesswork out of deciding what to invest in. Mutual funds are also considered to be a less risky investment than buying individual stocks and bonds because even if one stock were to decrease, you still have a pool of other investments that won’t necessarily be affected.

How Do Mutual Funds Work?

When an investor buys shares in a mutual fund, they are buying partial ownership of the mutual fund company as well as its assets. This means that each share represents an investor’s part ownership in the fund and the income it generates. The combined holdings of the mutual fund are known as its portfolio. 

Net Asset Value (NAV)

The price of the mutual fund is known as its net asset value (NAV). The NAV is determined by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders. This price fluctuates based on the value of the securities held by the portfolio at the end of each business day. 

Fees

Mutual funds come with fees, which can vary greatly from fund to fund. The 2 most common mutual fund fees are expense ratios and load fees. Expense ratios are the annual operating expenses for owning the mutual fund, and load fees are the sales and commission charges for buying and selling the mutual fund. However, not all mutual funds charge load fees — funds that don’t charge load fees are called no-load mutual funds. Some funds also charge fees and penalties for early withdrawals or selling the holding before a specific time has elapsed.

Active vs. Passive Mutual Funds

A mutual fund’s fees will also depend on whether it’s actively or passively managed. Actively managed funds have a professional manager or management team making all the decisions about how to invest the fund’s money — they aim to beat the market. Due to the active involvement of professionals, actively managed mutual funds are more expensive to own. Passively managed funds, on the other hand, typically still have fund managers, but their focus is to fund investments that align with a specific index (such as the S&P 500). Since there’s less work involved for fund managers, passively managed index funds are cheaper to own. 

Mutual Fund Investments

To know if mutual fund investments are right for you, you’ll want to evaluate your investment goals, risk tolerance, and preferences. Then, you can choose a mutual fund with an investment approach that fits all of the above.

How to Invest in Mutual Funds

Are you ready to invest in mutual funds? Follow these steps before you buy any mutual funds.

  1. Decide if you want to invest in active or passive mutual funds — Do you want a more hands-off approach that mimics the market and is cheaper to own? Or are you looking for professional input and research to beat the market?
  2. Understand the fees associated with the mutual fund — Make sure to research all the costs associated with the investment and consider if you can reasonably budget for the added fees.
  3. Determine the type of mutual fund you want to invest in — Beyond the active and passive designations, mutual funds are also divided into types (which will be discussed in further detail below), so it’s important to take the time to research which one fits your goals the best.
  4. Choose where to buy the mutual fund — Most investors opt to purchase mutual funds from an online brokerage, but you can also buy directly from the company that created the fund, such as Vanguard. You may also already be investing in mutual funds if you contribute to an employer-sponsored retirement account, such as a 401(k)

Types of Mutual Funds

There are a variety of different types of mutual funds. Some mutual funds focus on a single asset class, while others invest in a diverse set of asset classes and market segments.

Here are the main types of mutual funds:

  • Stock (equity) funds: These are higher-risk investments, but they also have the greatest potential returns. 
  • Bond (fixed-income) funds: These funds are typically less risky than stock funds. They invest in corporate or government debt and are geared toward generating interest income. 
  • Money market funds: These typically have the lowest risk and lowest returns. They invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations, usually in the form of Treasury bills.
  • Balanced funds: These are a mix of stocks, bonds, and other assets. These funds (also known as asset allocation funds or hybrid funds) intend to reduce the risk of exposure across asset classes by balancing them out.
  • Index funds: Passively managed mutual funds, these attempt to match the performance of a major market index (like the Dow Jones Industrial Average (DJIA)).  
  • International funds: These funds invest in overseas assets to provide more diversification and reduce risk.
  • Specialty funds: An all-encompassing classification of funds, these types of mutual funds tend to be more industry-specific and concentrate on a certain segment of the economy or a targeted strategy.
  • Target-date fund: This is a portfolio of investments that automatically chooses and reallocates assets toward safer investments for investors with a target date for retiring.

Mutual Funds Pros and Cons

Pros Cons
Professional management: As an investor, you don’t have to figure out the best stocks and assets to invest in because a professional manager reviews and manages the portfolio on an ongoing basis using expert research.Fees: There are a variety of fees that may be associated with mutual funds. There might be transaction charges, load fees, redemption fees (if you sell shares you’ve only owned for a short time), advisory fees, and expense ratios.
Liquidity and ease: Mutual funds are easy to buy and sell, making them highly liquid investments.Potential principal losses: The performance of funds isn’t guaranteed, so there’s always the potential for a loss of principal on the investment.
Lower costs: Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are typically lower than what you would pay as an individual investor.Dilution: At times, a fund’s diversification can have a diluting effect on returns. Because mutual funds can have small holdings in many different companies, high returns from a few investments often don’t make much difference in the overall return. 
Diversification: Mutual funds let you access a wide mix of asset classes, which helps to reduce risk and potentially enhance a portfolio’s returns.  Lack of control: Some investors may not like the lack of control around which securities are purchased and not knowing the exact makeup of the fund’s portfolio ahead of time.

Are Mutual Funds a Good Investment?

Mutual funds are considered a smart and cost-effective way to invest your money. For investors looking to diversify their portfolios, investing in mutual funds is a good way to do that while mitigating risk. Rather than placing all your eggs in one basket and building a portfolio one stock or security at a time, mutual funds allow you to buy multiple securities. This minimizes risk and makes it simpler for novice investors to jumpstart their ventures. Mutual funds are also highly liquid, meaning they’re easy to buy or sell. For someone with little money to invest or little experience, mutual funds take the guesswork out of managing a portfolio of securities, which makes them well worth looking into.

FAQs

Mutual funds vs. stocks: What’s the difference?

Stocks are individual shares in a company, while mutual funds can include a multitude of stocks and other securities. Mutual funds are considered to be less risky than owning individual stocks because of diversification.

Mutual funds vs. exchange-traded funds (ETFs): What’s the difference?

Mutual funds and ETFs are similar in some ways, but they also have some key differences. Both are managed by experts and invest in a portfolio of assets. But one major difference is that mutual funds are priced and traded once a day, while ETFs are bought and sold on exchanges throughout the trading day, and their share prices are constantly fluctuating. Furthermore, most ETFs are passive investments, while mutual funds are both actively and passively managed.

How do I buy mutual funds?

Most investors buy mutual funds online directly from a fund provider, through an investment company, or an online brokerage. Make sure you can meet the minimum investment requirements before committing to a mutual fund investment. Also, look into how you can waive the fees and minimums if you qualify. For example, some fees and account minimums are waived or discounted for clients who maintain online-only accounts.

When do mutual funds trade?

Mutual funds trade only once per day after the markets close at 4 p.m. EST.

Do mutual funds reduce risk?

Mutual funds mitigate risk through diversification, as the mixing of investments and assets within a portfolio reduces risk. Unlike investing in an individual asset, you’ll have other stocks or investments to fall back on when you invest in mutual funds.

Who manages a mutual fund?

Mutual funds are managed by professional fund managers who are responsible for executing a fund’s investment strategy and managing its portfolio. Fund managers can be one person or a team of people.

Final Thoughts

All in all, mutual funds are a simple and convenient way to invest in a basket of securities. They are managed by professionals and allow you the comfort of knowing that despite downturns in the market, your diverse portfolio will generally be less risky than other types of investments. That being said, all investments carry some risk and can potentially cost you money, so you should always proceed with caution when investing. And remember that mutual funds are generally long-term investments, so it might take some time to see quality returns. Stick with it, though, as your investments will likely grow in value over time. 

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