Often, when the price of one security falls in value, others can go up—or at least fall less. But buying dozens of stocks, bonds, or other securities can be time-consuming and inefficient. Mutual funds, bundled investment products that combine stocks, bonds, and other securities together into one package, are designed to answer this need.
How to invest in mutual funds
Buying and selling mutual funds is a relatively simple process for investors of any experience level or net worth. Here are some of the main steps:
- Decide on the investment goal. Is the purpose of this investment to track a specific stock market index, generate dividend income, or invest in a particular commodity? Knowing the goal of the mutual fund can help investors begin their search. By evaluating their own risk tolerance, investors can also determine if a particular mutual is a good match.
- Research. Investors can research a mutual fund’s past performance, asset mix, and how it stacks up against other mutual funds. Lastly, investors can use a mutual fund calculator to evaluate how much the fund’s management charges.
- Open an account. Before buying a mutual fund, most investors will need to open a brokerage account. This can be done either through an online platform or through a traditional brokerage firm. This account will need to be funded with money deposited from another account, such as a bank checking or savings account.
- Buy shares of mutual funds. Once a mutual fund has been chosen and a brokerage account established, investors can begin purchasing shares from the mutual fund provider. Mutual fund shares trade on stock exchanges once a day at the end of the trading session. The minimum investment required will vary by fund, and the initial purchase may also include upfront charges, known as load fees.
What to consider before buying a mutual fund
Before buying a mutual fund, an investor may take into account the following factors.
Fees and costs
Mutual funds are professionally managed investments, meaning that they incur management costs. These mutual fund fees—referred to as the fund’s expense ratio—will vary from one fund to the next, based on factors such as how actively managed the mutual fund is and what sort of securities it includes. The expense ratio is expressed as a percentage, reflecting how much of each dollar invested in the fund goes to the managers.
Managers of these funds charge fees that are paid directly out of the fund’s assets, so there isn’t an additional bill for investors to pay.
All investments include some level of risk. Mutual funds are no exception and depending on the exact mutual fund (and even what type of fund it is), this risk can vary greatly. This means that while a mutual fund has the potential to gain value over time and even provide the investor with dividends, it also has the potential to lose some—or even most—of its value without warning.
With that said, mutual funds do have the benefit of being redeemable investments. This means that investors can cash in their shares at any time by selling the investment back to the fund provider.
Past performance is never a guarantee of future results; the securities held in a mutual fund always have the potential to lose value, depending largely on how the market performs.
However, past performance can give investors an idea of how volatile a specific fund is, or whether it has been relatively stable. When it comes to mutual funds that invest in a specific market or even stock index, checking the past performance of those linked investments can also be a valuable research tool.
Types of mutual funds
There are many different types of mutual funds to choose from, depending on the investor’s interests, risk tolerance, and current portfolio diversification. These include:
- Equity funds. Equity, or stock, mutual funds are investments that pool shares of publicly traded companies. These could include index funds, international funds, sector-specific funds, and other types of specialty funds. Equity funds are one of the most common types of mutual funds.
- Bond funds. These mutual funds invest in an asset class known as fixed-income securities. These may invest in U.S. Treasury bonds, or municipal and corporate debt. They offer investors a fixed minimum return.
- Money market funds. Money market funds are a low-risk type of mutual fund that offers investors a rate of return a bit higher than the returns offered on bank deposits. The funds invest in various securities, such as short-term government, bank debt, or corporate debt. Investors often use them to hold cash to eventually use for other investments.
- Target-date funds. These funds are established and managed according to a specific target date, often the time when an investor expects to retire.
Frequently asked questions
What’s the difference between a mutual fund and an ETF?
Mutual funds and exchange-traded funds (ETFs) are similar in some respects, offering a blended investment product that combines many different assets for diversification purposes. However, there are some important differences when comparing mutual funds versus ETFs.
The first is that mutual funds can only be traded at the end of the trading day, based on the fund’s calculated net asset value (NAV). This NAV represents the actual per-share value of a mutual fund at any given time, according to its total assets minus its total liabilities. ETFs, on the other hand, can be purchased on an exchange throughout the trading day just like shares of stock, with prices that fluctuate with supply and demand and investor expectations.
Mutual funds are typically actively managed funds, meaning a manager selects the fund’s securities, which often results in higher costs. While a small number of ETFs are actively managed, most are passively managed investments that simply track an index. For this reason, they tend to have lower fees and expense ratios than mutual funds.
How do mutual funds make money for investors?
Mutual funds can make money for investors in a few different ways.
First, the value of the mutual fund can increase as the blend of securities held in the fund gains value. If and when an investor chooses to sell their mutual fund shares, they will recognize a gain from their original purchase price of the shares.
Second, some mutual funds pay out dividends to investors based on the assets held in the fund. These dividends can serve as a source of passive income for the investor, or can be reinvested into the fund to purchase additional shares. However, these dividends payments, as well as any capital gains the fund has when the manager sells a security for a profit, will create a tax liability for the investor.
Can money be lost in mutual funds?
Any investment carries risk, and mutual funds are no exception. While some mutual funds are less volatile than others, there is no way to predict future performance, and any mutual fund has the potential to lose value.
The bottom line
Mutual funds offer investors a convenient way to diversify and invest in a wide range of securities and assets. These funds can even be used to invest in specific markets, industries, commodities, or foreign securities through a domestic portfolio.
Because mutual funds are professionally managed, they do incur expenses. These can be higher than those found in some other blended investments, such as ETFs. Some mutual funds carry greater risk than others, so investors take into account their tolerance for risk when deciding which funds to acquire.