How to Invest in Mutual Funds
Diversify your investment portfolio with mutual funds.
If you want to know how to invest in mutual funds, you've come to the right place. Mutual funds are an important investment vehicle and a cornerstone of many investor's portfolios. However, not all mutual funds are the same. Keep reading to learn how to buy mutual funds and what steps you should take to make sure your investments are right for your goals.
1. Identify Goals and Risk Tolerance
Before you invest, think about why you want to put your money into a mutual fund. You should never rush into any investment without first thinking about your short-term and long-term goals as well as the level of risk involved.
- Mutual funds are generally best for longer-term goals. For short-term investments, exchange-traded funds (ETFs) are a better choice (If you're looking to invest in ETFs, Public.com is a great broker).
- Every investment has a different risk profile. Matching your investments to your personal risk tolerance and goals is vital for success.
- Mutual funds are generally considered less risky than stocks and have a similar risk to many ETFs. Because a mutual fund typically includes many stocks, investors are not at risk of significant losses due to the poor performance of just one company. Funds spread out your risk among many different stocks. This lowers your overall investment risk. You can read more about how mutual funds work here.
2. Choose Between Passive and Active Funds
Next, decide which type of fund you want to invest in. There are many ways to categorize mutual funds, so we will start with the most basic one: whether the funds are actively or passively managed.
What's the difference?
- Passive fund management is usually in the form of index funds. The goal of a passive fund manager is to match the gains of the market. Not only are these investments more consistent over the long run, but they're also more affordable.
- Actively managed funds You'll have the around-the-clock skill of fund managers who have built their careers around bringing profits to their clients. These managers will be actively trading investments for their funds to try to beat a particular benchmark (in most cases, a market index).
The Tradeoff? Although there's the potential for higher profits, active fund managers traditionally charge high fees. Plus, recent research indicates that over the long term, active management does not necessarily consistently beat the market.
What to look for before buying into any actively-managed mutual fund
- Category – The fund category (small, medium, or large-cap stocks) says a lot about the potential for a fund to outperform the market. Keep in mind that it is much easier for smaller funds to produce outsized returns in the small and medium cap corners of the stock market than it is for a large fund to do the same in large-cap stocks. A manager can add a lot more value in less watched small-cap stocks than he or she can in large-cap stocks.
- Turnover – Funds with less asset turnover will produce better results in the long-run. Remember that mutual funds have an unbelievably large amount of money to move around and usually have to add or subtract capital from a position in a maneuver that may take several days or a week to complete. Over the course of days and weeks, large funds can easily push up or down the price of an individual stock, dragging down the fund’s performance.
- Cash position – Don’t be a fool for fund marketing. Many actively-managed funds have created “aggressive,” “moderate,” and “conservative” funds that hold cash in varying levels to meet investors’ risk tolerance. Some “conservative” funds hold as much as 50% of all invested capital in U.S. Treasury bills that mature in days and even weeks. Such investments earn less than 0.2% per year for investors at a cost of 1%-2% in fund management fees. Don’t pay money for an asset manager to keep your money in cash – the bank is better.
- Strategy – It’s common to see that the best performing funds in their class have very lenient strategies where virtually nothing is “set in stone.” When asset managers are confined to a very simple strategy or asset allocation, there really isn’t much wiggle room for someone to add value to the fund. However, when asset managers have free reign to chase the securities they find most interesting – whether they chase stocks, bonds, preferred shares, or complicated hedges – they can add more to a fund’s performance.
- Track record – While past performance never guarantees future results, past history does mean something. I like to see funds with a long history of good management and love the small-time family funds that frequently appear atop long-run performance charts. Long-lived management teams are no longer in the business for money anymore; they’re in it because they enjoy it. Otherwise, a few years of stellar performance would have sent them packing for retirement in the Hamptons.
3. Decide on Fund Types and Styles
Once you decide between active and passive funds, you still have more choices to make. There are mutual funds designed for just about every investment preference, industry, and corner of the market.
Here are some common fund types you might come across:
- Index mutual funds: Index funds follow specific stock market indices. These include S&P 500 index funds and many others.
- Sector mutual funds: Sector-specific mutual funds track stocks in certain industries. For example, some funds focus on technology companies. Others focus on defense companies or pharmaceutical companies.
- Market-cap mutual funds: Small-cap, mid-cap, and large-cap funds allow you to invest based on the size and stage of a company.
- Geography mutual funds: Some funds include stocks only from the United States. Others feature only international stocks, perhaps stocks from specific regions. Still, others include stocks meeting specific international criteria, such as developing markets.
- Target date funds: Target-date funds are a type of fund that's managed to keep risk appropriate for people retiring during specific years.
- Bond funds: There are many bond fund varieties. You can get government bond funds, corporate bond funds, and municipal bond funds.
- Specialty funds: Some funds follow specific rules and guidelines. For example, the Vice Fund focuses on stocks in tobacco, gambling, defense, and alcohol industries. There's a fund for everyone.
Morningstar and other agencies rate mutual funds. Research the ratings, reports, and past performance to decide if a fund is right for your goals.
4. Calculate Your Mutual Fund Investment Budget
Investing takes money. You can start investing in stocks and ETFs with very small amounts of money, sometimes less than $5. But it takes a bit more to invest in mutual funds. As with any investment, it's a good idea to use only money that you won't need in the short term. Never, ever use money from your emergency fund.
When deciding how much to allocate to mutual funds, consider these two key questions:
- What's the minimum investment for the fund? Mutual funds often carry minimum investment requirements. This means you may have to save up hundreds or thousands of dollars to get started.
- What fees does the broker charge for investing in mutual funds? What other management fees are there? A fund manager might charge high fees, on top of the commissions charged by the broker. If you like a specific mutual fund company, perhaps from somewhere like Fidelity, Vanguard or Charles Schwab, it could make sense to open a brokerage account there to avoid minimums and trade commissions.
5. Choose the Right Brokerage for Your Mutual Funds
Outside of choosing a brokerage because you prefer its specific funds, there are other reasons to pick a brokerage when you're ready to start investing in mutual funds. Here are some considerations when choosing the best brokerage for mutual funds:
- Account minimums and fees: Try to find an account with no minimum balance requirement and no recurring fees.
- No-transaction-fee fund list: Most brokers have a list of funds with no commissions or transaction fees. This may be called a “no-load fund” list.
- General mutual fund availability: Not every broker offers access to every mutual fund on the market. Find out what's available, so you know if you have a good choice of funds.
- Mutual fund trade commissions: If you do decide to buy a mutual fund with a trade commission or load fee, you should know what to expect. Commissions range from around $10 to $50 per trade.
If you're like most folks and want to play it safe, you can purchase passively managed mutual funds at most online brokerages. TD Ameritrade is one of our favorite brokers overall, and it offers hundreds of no-load mutual funds. If you're interested in a mutual fund that isn't on the freebie list, check out Ally Invest. Mutual funds here cost only $9.95 in commissions.
If you're looking to get started right away, check out our list of the best brokerages to learn more.
6. Understand and Scrutinize Mutual Fund Fees
As we briefly mentioned above, mutual funds generally come with management fees that can vary by the type of fund and how it's managed. Actively managed funds generally charge more than passive funds.
- There has been a race to the bottom with index fund fees over the last few years. Thanks to intense competition, the average cost of mutual funds has come down quite a bit. In fact, Fidelity has come out with a list of funds with no fees at all.
- Fund fees are charged as an annual percentage of assets you have invested with the fund. The fee is also called an “expense ratio.” The expense ratio tells you how much you pay for a mutual fund. This helps you compare similar funds based on cost.
- That can be a confusing concept to newer investors, so here's how it works in practice: Let's say you have $1,000 invested in a fund with a 0.1% expense ratio. For that investment, you pay $1 per year in management fees. You'll pay more as your balance goes up. This is why it's important to avoid high-fee mutual funds when you're hunting for potential investments.
7. Build and Manage Your Portfolio
Now it's time to buy shares and build up your investment portfolio. Mutual funds bring you instant diversity in your portfolio with a single purchase. However, you most likely will want to build a portfolio of different mutual funds to give you even more diversity and align your investments with various goals.
Anyone Can Invest in Mutual Funds
Mutual funds and ETFs are among the most important investments for modern investors. Mutual funds are often a cornerstone of long-term and retirement-focused investments. And these often make up the bulk of investor portfolios.
It doesn't take years of experience or a fancy degree to buy and hold mutual funds. By knowing how to invest in mutual funds, you're putting yourself on track for long-term investment success.
