Mutual funds are one of the most accessible ways to invest. They pool money from many investors to build a diversified portfolio of stocks, bonds, or other assets, giving you broad market exposure without the need to research and select individual securities yourself.
If you're new to mutual funds or want to make sure you're approaching them the right way, here's a step-by-step guide to getting started.
How to invest in mutual funds
1. Understand how mutual funds work
A mutual fund pools money from many investors and uses it to pursue a specific investment objective. For example, it wouldn't be practical for a single investor to buy all 2,000 stocks in the Russell 2000 index, but when millions of dollars are pooled together, it becomes possible.
Mutual funds have shares like stocks, but they don't trade continuously throughout the day. Instead, they price once per day, and that's the price at which new investors buy in and existing investors sell out.
2. Choose between active and passive funds
First, you should understand the difference between an actively managed and a passively managed mutual fund.
An actively managed mutual fund employs managers who select investments for the fund. A passive mutual fund simply tracks a benchmark index, such as the S&P 500.
Let's be clear: The goal of a passively managed mutual fund is to match the performance of a benchmark index. An actively managed mutual fund aims to beat a benchmark. For this reason, passive mutual funds are also known as index funds.
In practice, however, most active mutual funds don't outperform index funds. In any given year, 40% to 50% of actively managed funds beat their benchmarks. There are some excellent active mutual funds, but it's essential to review a fund's track record before investing.
3. Understand the costs
Before you invest, you should know how much a mutual fund costs. The main type of fee you should be aware of is the expense ratio, which is the percentage of the fund's assets that goes toward annual fees. For example, a 1% expense ratio means you'll pay $100 in yearly investment fees on a $10,000 account.
Passive mutual funds tend to have expense ratios in the 0.03% to 0.25% range. Active mutual funds tend to have higher expense ratios, often in the ballpark of 1% because they have the added expense of paying investment managers.
It's important to mention that an expense ratio isn't a fee you have to pay. It will simply be reflected in the fund's performance over time.
Some mutual funds charge a sales commission, known as a sales load or, simply, a load. A front-end load is a commission paid when you buy the fund, while a back-end load is a commission paid when you sell. That said, there are many great no-load mutual funds in the market, so you should generally avoid any mutual fund with a sales load.
4. Decide between stock and bond funds
You can find mutual funds that invest in many asset classes, but most invest in either stocks (equities) or bonds (fixed income).
Investors should generally have some of each in their portfolio. Older, less risk-tolerant investors should generally focus more on bonds, while younger investors are better off maintaining a more stock-heavy allocation.
One good rule of thumb is to subtract your age from 110 to get a ballpark idea of your appropriate stock allocation. For example, if you're 40, you should have roughly 70% of your invested assets in stocks and the other 30% in bonds or fixed-income investments.
5. Decide how much to invest
You should weigh a few factors when deciding how much to invest. First, most mutual funds have minimum investment requirements.
For example, one of the most widely held active mutual funds, the Dodge & Cox Stock Fund (DODGX -0.18%), has a $2,500 minimum initial investment for standard accounts and a $1,000 minimum if you invest through an individual retirement account (IRA). Additional investments (added to an existing one) must also be at least $100. Be sure to check fund minimums before investing.
Advantages and disadvantages of investing in mutual funds
There are some significant benefits of investing in mutual funds. For one thing, it allows you to invest in stocks and other assets without too much homework on your part. It can also help you avoid market "noise," since mutual funds don't trade continuously and price their shares only once per day.
There are also some drawbacks to mutual fund investing. One is that they don't trade on stock exchanges and therefore cannot be instantly bought and sold as stocks and ETFs can. Plus, mutual funds typically have minimum initial investment requirements that vary from fund to fund.
Strategies for investing in mutual funds
There's no perfect strategy for investing in mutual funds that works for everyone. But here are a few to keep in mind.
- Make it automatic: Perhaps the most effective way to invest in mutual funds is to build your investments over time by making automated contributions. For example, you might set up an automatic $50 transfer to your mutual funds on every paycheck.
- Diversify: By definition, mutual funds are diversified investments -- especially compared with buying individual stocks. But mutual funds often have a specific investment objective, so it can be smart to hold several different types. For example, you might invest in an S&P 500 index fund, a bond mutual fund, a small-cap stock fund, and an international stock fund, just to name a few possibilities.
- Rebalancing: Although mutual funds are designed as passive investment vehicles, it's still important to check your portfolio regularly. One reason is rebalancing. As mutual fund values change over time, it's important to make sure your desired asset allocation is maintained, and to make periodic adjustments when needed.
The bottom line
The bottom line is that mutual funds can be a great way to invest for the long term without worrying about selecting individual stocks and bonds. By understanding the basic concepts discussed here, you'll be equipped to construct a rock-solid mutual fund portfolio of your own.
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