How to Invest in Mutual Funds
Mutual funds can be an excellent opportunity for investors to diversify. Here’s what you need to know about investing in mutual funds to help grow and balance your portfolio.
The total net assets of US mutual funds were approximately US$34.15 trillion in 2021. Why are so many investors picking mutual funds over other investment options?
Diversification is the cornerstone of a strong investment portfolio, and mutual funds help investors reach this goal. A mutual fund typically invests in various securities, including bonds, short-term debt and stocks. An individual investor buys into the mutual fund, and then the fund’s manager makes continual transactions for the ultimate profit of investors.
Keep reading to learn more about how mutual funds work, whether they fit your portfolio and how you can get started.
What is a mutual fund?
A mutual fund is a specific type of financial vehicle that pools investments from shareholders to invest in a range of assets, including bonds, stocks, money market instruments and other assets.
Mutual funds are managed by professional money managers, which gives individuals access to a managed fund without requiring significant capital. Instead of working for you individually, the mutual fund’s manager combines all investors' assets to make strategic transactions to improve shareholder value.
However, just like any investment, investors should carefully consider a fund’s history, prospectus and manager before buying.
Are mutual funds a good investment?
Mutual funds can be a great investment, provided you conduct due diligence before investing and the fund aligns with your investment goals and risk tolerance.
Average mutual fund returns vary by category, with US large-cap stock funds demonstrating a three year return of 23.84 percent in 2021, contrasted by 3.02 percent for short-term bond funds in the same timeframe.
Understanding the pros and cons of mutual funds can help you determine if they’re the right financial vehicle for your portfolio.
Pros of mutual funds include:
- Benefit from having a professional manager continuously reviewing and researching the mutual fund’s portfolio to increase value.
- Diversification into a range of assets by making a single investment. Every mutual fund has a prospectus detailing how it will make investment decisions and which asset classes it will target.
- Strong liquidity as investors can redeem shares at any given day for the current net asset value, plus any redemption fees.
Are there any drawbacks to mutual funds? Some notable disadvantages include the following:
- There are no guarantees on returns, and you may still lose value, just like any other investment.
- Potential for dilution, meaning a previously successful fund receives an influx of cash and the money manager struggles to find suitable investments with new capital. Dilution can result in the wrong type of diversification that can harm the mutual fund.
- Only end-of-day redemptions, making them a poor choice for those looking to day trade. Mutual funds are typically considered a more long-term investment.
Mutual funds can be an excellent choice for investors looking to take a more passive approach to grow value. You passively put money into the fund while a money manager manages everyone’s investments to increase value. The money manager themself may take an active or passive role. A passive mutual fund aims to replicate a broader benchmark like the S&P 500 (INDEXSP:.INX), while an active mutual fund is more narrowly focused on specific managed investments.
How much of your portfolio should be invested in mutual funds? Many investors adhere to the 5 percent rule, which states you should allocate no more than 5 percent of your portfolio to one investment security.
However, since mutual funds involve multiple securities, you can put more than 5 percent into mutual funds while still following this guideline. Ultimately, it depends on your risk tolerance and investment goals.
How to invest in mutual funds?
Most brokerage accounts used for buying stocks and bonds will provide access to mutual funds. If you’re setting up a new brokerage account focusing on mutual funds, thoroughly investigate which funds are accessible, any relevant fees and the fund’s prospectus. Your brokerage account will typically have a specific interface for buying mutual funds, or they may be included in the standard trading dashboard.
There are a few key considerations when picking the right mutual fund, such as:
- Do you want a passive or active mutual fund?
- How much of your portfolio do you want to put into mutual funds?
- What are the fund’s fees?
- What type of mutual fund best suits your goals? Funds can target a range of securities, which will be explicitly stated in the prospectus.
- Does the mutual fund pay dividends?
Top mutual funds have a 10 year annualized return ranging from 7 percent to 11.9 percent, while shorter-term returns are significantly lower. Therefore, look at historical performance and focus on long-term results when picking a mutual fund.
Traditionally, buying into a mutual fund requires a flat dollar amount, such as $500. Other mutual funds can be purchased at fluctuating prices, similar to stocks. Fractional shares are a growing trend that may be available based on your brokerage.
Mutual funds vs. ETFs and stocks
How do mutual funds compare to exchange-traded funds (ETFs) and stocks? There are certainly similarities and differences to understand before investing.
Mutual funds vs. ETFs
Both financial instruments allow you to buy into multiple securities, but they have important differences. A key distinction is that ETFs trade like stocks on an exchange, while mutual funds can only be bought at the end of the trading day. Another is that most mutual funds are actively managed, while ETFs tend to be passively managed; as a result, ETFs tend to be a cheaper option.
Mutual funds vs. stocks
A stock is a single company for which you can puchase shares to earn dividends or buy low and sell high. Conversely, mutual funds are generally comprised of shares from several companies and asset classes.
Mutual funds are an excellent addition to a well-rounded portfolio focusing on long-term growth. However, they are typically not ideal for day trading, and instead are used to build a solid foundation for accruing wealth over years or decades.
Take caution when investing in a mutual fund, and perform due diligence before buying in. Read through the prospectus, understand all associated fees and be aware of whether it's passive or active. Just like any other investment, take your time to research all the moving pieces before investing.
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