Mutual Funds: What Are They and How to Invest

Investing in mutual funds calls for deciding between active or passive management, choosing where to buy funds, understanding fees and sticking to a plan.
Kevin VoigtJun 30, 2021
how to invest in mutual funds

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Steps

Mutual fund investors own shares in a company whose business is buying shares in other companies (or in bonds, or other securities). Mutual fund investors don’t directly own the stock in the companies the fund purchases, but they do share equally in the profits or losses of the fund’s total holdings — hence the “mutual” in mutual funds.

A mutual fund is an investment that pools money from investors to purchase stocks, bonds and other assets. A mutual fund aims to create a more diversified portfolio than the average investor could on their own. Mutual funds have professional fund managers buy securities for you.

» Do your investments need a home? NerdWallet's roundup of the 

A mutual fund's fees and performance will depend on whether it is actively or passively managed.

Passively managed funds invest to align with a specific benchmark. They try to match the performance of a market index (such as the S&P 500), and therefore typically don’t require management by a professional. That translates into lower overhead for the fund, which means passive mutual funds often carry lower fees than actively managed funds.

Here are two types of mutual funds popular for passive investing:

1. are made up of stocks or bonds that are listed on a particular index, so the risk aims to mirror the risk of that index, as do the returns. If you own an S&P 500 index fund and you hear that the S&P 500 was up 3% for the day, that means your index fund should be up about that much, too.

2. can be traded like individual stocks, but offer the diversification benefits of mutual funds. In many cases, ETFs will have a lower minimum investment than index funds.

Actively managed funds have a professional manager or management team making decisions about how to invest the fund's money. Often, they try to outperform the market or a benchmark index, but studies have shown.

Beyond the active and passive designations, mutual funds are also divided into other categories. Some mutual funds focus on a single asset class, such as stocks or bonds, while others invest in a variety. These are the main types of mutual funds:

» Learn more:

When you buy into a mutual fund, your investment can increase in value in three ways:

1. Dividend payments: When a fund receives dividends or interest from the securities in its portfolio, it distributes a proportional amount of that income to its investors. When purchasing shares in a mutual fund, you can choose to receive your distributions directly, or have them reinvested in the fund.

2. Capital gains: When a fund sells a security that has gone up in price, this is a capital gain. (And when a fund sells a security that has gone down in price, this is a capital loss.) Most funds distribute any net capital gains to investors annually.

3. Net asset value: Mutual fund share purchases are final after the close of market, when the total financial worth of the underlying assets is valued. The price per mutual fund share is known as its net asset value, or NAV. As the value of the fund increases, so does the price to purchase shares in the fund (or the NAV per share). This is similar to when the price of a stock increases — you don’t receive immediate distributions, but the value of your investment is greater, and you would make money should you decide to sell.

All investments carry some risk, and you potentially can lose money by investing in a mutual fund. But diversification is often inherent in mutual funds, meaning that by investing in one, you’ll spread risk across a number of companies or industries. Investing in individual stocks or other investments, on the other hand, can often carry a higher risk.

Time is a crucial element in building the value of your investments. If you'll need your cash in five years or less, you may not have enough time to ride out the inevitable peaks and valleys of the market to arrive at a gain. If you need your money in two years and the market drops, you may have to take that money out at a loss. Generally speaking, mutual funds — especially equity mutual funds — should be considered a long-term investment.

If you're ready to invest in mutual funds, here is our step-by-step guide on how to buy them.

» Interested in mutual funds? Here's a list of the

Your first choice is perhaps the biggest: Do you want to beat the market or try to mimic it? It's also a fairly easy choice: One approach costs more than the other, often without delivering better results.

Actively managed funds are managed by professionals who research what's out there and buy with an eye toward beating the market. While some fund managers might achieve this in the short term, it has proved difficult to outperform the market over the long term and on a regular basis.

Passive investing is a more hands-off approach and is rising in popularity, thanks in large part to the ease of the process and the results it can deliver. Passive investing often entails fewer fees than active investing.

» Check out the

Thinking about your budget in two ways can help determine how to proceed:

How much do mutual funds cost? One appealing thing about mutual funds is that once you meet the minimum investment amount, you can often choose how much money you’d like to invest. Many mutual fund minimums range from $500 to $3,000, though some are in the $100 range and there are a few that have a $0 minimum. So if you choose a fund with a $100 minimum, and you invest that amount, afterward you may be able to opt to contribute as much or as little as you want. If you choose a fund with a $0 minimum, you could invest in a mutual fund for as little as $1.

Aside from the required initial investment, ask yourself how much money you have to comfortably invest and then choose an amount.

Which mutual funds should you invest in? Maybe you’ve decided to invest in mutual funds. But what initial mix of funds is right for you?

Generally speaking, the closer you are to retirement age, the more holdings in conservative investments you may want to have — younger investors typically have more time to ride out riskier assets and the inevitable downturns that happen in the market. One kind of mutual fund takes the guesswork out of the “what's my mix” question: target-date funds, which automatically reallocate your asset mix as you age.

» What’s the right number of funds? Here’s our guide on

You need a brokerage account when investing in stocks, but you have a few options with mutual funds. If you contribute to an employer-sponsored retirement account, such as a 401(k), there’s a good chance you’re already invested in mutual funds.

You also can buy directly from the company that created the fund, such as Vanguard or BlackRock, but doing so may limit your choice of funds.

Most investors opt to buy mutual funds through an online brokerage, many of which offer a broad selection of funds across a range of fund companies. If you go with a broker, you'll want to consider:

Whether you choose active or passive funds, a company will charge an annual fee for fund management and other costs of running the fund, expressed as a percentage of the cash you invest and known as the . For example, a fund with a 1% expense ratio will cost you $10 for every $1,000 you invest.

A fund’s expense ratio isn’t always easy to identify upfront (you may have to dig through a fund’s prospectus to find it), but it's well worth the effort to understand, because these fees can eat into your returns over time.

» How do fees impact returns? This

Mutual funds come in different structures that can impact costs:

Whether or not funds carry commissions is expressed by “loads,” such as:

» Ready to go?

Once you determine the mutual funds you want to buy, you'll want to think about how to manage your investment.

One move would be to rebalance your portfolio once a year, with the goal of keeping it in line with your diversification plan. For example, if one slice of your investments had great gains and now constitutes a bigger share of the pie, you might consider selling off some of the gains and investing in another slice to regain balance.

Sticking to your plan also will keep you from chasing performance. This is a risk for fund investors (and stock pickers) who want to get in on a fund after reading how well it did last year. But "past performance is no guarantee of future performance" is an investing cliche for a reason. It doesn't mean you should just stay put in a fund for life, but chasing performance almost never works out.

Still trying to decide if mutual funds are for you? Here are the pros and cons.

These are the primary benefits to investing in mutual funds:

Here are the major cons of mutual funds:

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