- You can start investing in mutual funds through goal planning and choosing between active or passive investing strategy.
- Mutual funds are typically actively managed, but there are passive mutual funds like index funds.
- When you invest in mutual funds be aware of sales loads and expense ratios fees, which can add up.
Investing your money can help you turn one dollar into many more, giving you the ability to build wealth without having to work harder. Thanks to compound interest and a variety of investment vehicles, you can decide where to put your money.
One type of investment vehicle that can help diversify your money is a mutual fund, which gets money from investors and pools it together into a fund. These funds invest in various securities like stocks, bonds, and short-term debt. Mutual funds are often actively managed, but not always.
Here’s how to get started investing in mutual funds.
Step 1: Look at your finances and goals
Before you get started with investing in mutual funds, it’s important to first review your current income, expenses, monthly debt obligations, and net worth to see where you’re at financially.
You wouldn’t build a house without laying a proper foundation – and the same goes with your finances. Having an emergency fund and manageable debt are important if you want to invest. Why? Because investing is risky, no matter how you look at it. There are ways to minimize your risk by figuring out your risk tolerance, but it’s crucial you have that financial foundation and safety net set up.
Knowing where your finances are at now can inform how much you can afford to invest and what your asset allocation should be based on your risk tolerance.
On top of that, consider your short- and long-term goals when investing, too. Will this be used for a down payment in five years? Or for your retirement in 30 years? Knowing your goals and having a rough timeline can ensure that you stay on track and know why you’re investing in the first place.
Step 2: Research types of mutual funds
According to the Securities and Exchange Commission (SEC), a mutual fund is an open-end investment company that is registered with the SEC and gathers money together from various investors to put into asset classes like stocks, bonds, and more.
When you invest in mutual funds, you end up purchasing shares of the mutual fund that reflects partial ownership of the total portfolio.
“Mutual funds are baskets of various stocks with a common theme behind them, such as ‘US Equities Growth Fund’ or ‘Sustainable Developed Markets Fund.’ They usually have a net asset value, which is determined once per day, unlike stock prices that fluctuate during the day in the markets,” explains Gary Grewal, a Certified Financial Planner and author of “Financial Fives: The Top 325 Ways to Save, Earn, and Thrive to Retire Before 65.”
There are many different types of mutual funds that you can invest in:
- Stock funds: These invest in a company’s stock. There are some nuances within stock funds, including those that focus on investing in a company’s stock, growth-focused stocks based on financial returns, income-focused stocks that produce dividend payouts, stock funds based on certain sectors, as well as index funds that track specific indexes and seek to produce similar results.
- Bond funds: This is a type of investment company that’s focused investing in bonds and debt securities. The risk related to bonds can differ depending on the bond. As an investor, the SEC recommends that you consider the credit risk if the bond issuer fails to pay back debt, how interest rate fluctuations will affect the value of a bond fund, as well as prepayment risk and what will happen if the bond issuer pays back the bond earlier than anticipated.
- Money market funds: These have the least risk and invest only in particular investments that are issued by the US government or corporations.
- Target-date funds: These contain a combination of stocks and bonds that aim to help you retire by a certain date, called target-date funds. They can also be referred to as lifecycle funds as well. The asset allocation will shift over time depending on the overall goal.
In many cases, mutual funds are actively managed by an investment professional. But it’s possible to invest passively in mutual funds as well, typically called an index fund. Also: mutual funds can be index funds – and vice versa.
Actively managed mutual funds work with a professional manager whose main goal is to help you beat the market. They do much of the heavy lifting when it comes to choosing securities to invest in and review the performance.
Passively managed funds like index funds have an objective to match the results of a particular index and don’t have a professional manager. As such, it’s a passive way to invest as there’s no outside help. No outside help typically means lowers costs.
In order to diversify your investments, you’ll want to invest in various types of mutual funds and not just one type in a specific sector.
Quick tip: Target date funds are easily recognizable as they typically include the target date, such as the Fidelity Freedom 2050 Fund.
Step 3: Choose a passive or active strategy
After researching the various types of mutual funds out there, you want to be clear about whether you want to have a passive or active strategy.
Actively managed mutual funds are costlier, as they are rife with fees, can take a chunk out of your investments, and may also lead to tax events.
For example, there may be mutual fund distributions that you need to report and pay taxes on. When you invest in mutual funds, you can get capital gains distributions as well as dividend payments. This could be a good thing, but there may also be tax implications.
Depending on what your mutual fund manager does, it could lead to higher taxes because of the difference in holdings.
When you sell an asset, you’re expected to pay capital gains taxes if you hold the asset for longer than a year and there is an increase in value. If you hold it less than that, you’ll be taxed at the ordinary income rate, which is higher (which can be up to 37% compared to 20%).
Passively managed mutual funds, such as index funds, seek to replicate market returns of a particular index, such as the ever-popular S&P 500. They are more affordable for investors since there are lower fees as there’s not an entity that is managing the investment, as you’re managing it yourself.
“Active funds typically come with higher expense ratios and may even come with a sales charge. Active means there are human portfolio managers whose job is to manage the investments within the mutual fund to try and beat the market,” explains Grewal.
In many cases, actively managed funds don’t actually outperform passively managed funds in the long run.
“Multiple studies have shown over time it’s very hard to beat the market, so passive funds such as those that track the S&P 500 Index may be a better choice for those concerned about fees, as passive funds have expense ratios that are typically much lower than their active counterparts,” says Grewal.
To consider the impact and costs you can use the Fund Analyzer tool by the Financial Industry Regulatory Authority, or FINRA. You can also look at the mutual fund’s prospectus to get a breakdown of fees, risks, and overall performance. For both active and passive mutual funds, you also want to consider the expense ratio, which includes costs related to managing your account.
Step 4: Invest in mutual funds
After researching types of mutual funds and choosing a strategy, you want to get started investing in mutual funds.
“One can easily invest in mutual funds via their workplace retirement plan, IRA, or opening a brokerage account through Fidelity, Schwab, and Vanguard,” notes Grewal.
When you invest in mutual funds, you purchase shares from a brokerage or from the actual fund. How much you end up paying will vary based on the sales charge or sales load as well as the fund’s net asset value per share. You may be able to invest in mutual funds that don’t have a sales load associated with them as well.
Related Article Module: The best online brokerages for investors of all kinds, from kids to pros
To get started, choose a brokerage or company to invest in mutual funds. You can check out some popular options such as Fidelity, Vanguard, Charles Schwab, and Etrade. Before opening an account, be sure to review the prospectus and any fine print and also consider:
- Any account minimums required
- Usability of website and mobile app options
- Funds that are available
- Total costs such as sales load and expense ratio
After you open an account with a brokerage, deposit money into the account and then select the mutual fund you want to buy and purchase shares. Create a plan to add funds on a regular basis, such as each month, and review your performance as you go to see if any changes should be made.
Quick tip: Make sure to do some research to better understand how your various mutual fund types relate to your goals and time horizon. Focusing too much on stock funds for a short-term goal may not be the best idea.
The financial takeaway
If you want to get started investing in mutual funds, the main things to be aware of are active versus passive strategies and the costs that can come with each choice. Your choice will determine how much you pay and also if you take a hands-on or hands-off approach.
Investing in mutual funds can be an easy way to diversify your portfolio and also offer a straightforward redemption process if you want to redeem your shares.
5-step beginner’s guide to investing in index funds A CFP is an advisor armed with extensive education and ethical standards to help you manage your money Understanding what qualified dividends are why they’re taxed at lower rates How to invest in dividend stocks, a low-risk source of investment income