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How to Invest in Mutual Funds

Mutual funds offer a (relatively) easy way to invest in stocks or other financial assets – although they also involve some risk.

By Mike Faden | American Express Credit Intel Freelance Contributor

8 Min Read | August 13, 2020 in Money

 

At-A-Glance

Mutual funds are professionally managed funds that pool money from many investors and use it to buy stocks, bonds, and other financial assets.

They offer a convenient way to diversify your investments and help your money grow – although they also involve risk.

There’s a huge variety of mutual funds to choose from, offering different levels of potential reward and risk.

If you’re looking to invest your money for the long term, you may have heard that investing in mutual funds is a popular way to do it. If you decide to go that route, you won’t be alone. In 2018, roughly 45% of U.S. households owned shares in mutual funds, and they poured $191 billion into those funds during the year, according to Statista.1 

 

Like any responsible investor, you probably want to know more before investing your hard-earned cash in mutual funds – like how they work, how you invest in them, how they can earn you money, and what the risks are.

 

What are Mutual Funds?

Mutual funds are designed to offer an easy way to invest in stocks or other financial assets that may potentially help your money grow faster than it would in, say, a savings account. Mutual funds’ faster growth comes at the risk of losing your money. Of course, savings accounts have their own benefits, like government-insured safety and fast-and-easy access to cash. 

 

Mutual funds are created and operated by investment management firms. Each mutual fund sells shares to investors – including people like you and me – pools the money and uses it to buy a collection, or “portfolio,” of stocks, bonds or other financial securities. The firm’s investment managers decide which companies’ stocks or bonds they’ll add to the portfolio, and how much they’ll buy of each. 

 

Mutual funds are popular because they generally offer four key features, according to the U.S. Securities & Exchange Commission:2

  • Professional Management. Because fund managers do the research and manage the fund’s operations, you don’t need to research and buy individual stocks yourself.
  • Diversification. You don’t have to put all your eggs in one basket. Mutual funds invest in multiple companies and industries, which helps to reduce your risk if one company performs poorly.
  • Affordability. Most funds allow you to invest relatively small amounts at a time.
  • Liquidity. You can cash in your shares in the fund at any time.
Some Pros and Cons of Mutual Funds
Pros Cons
Professional management: you don’t have to research individual stocks yourself You can’t select or change the stocks or other assets in each fund
Diversification: the risk may be lower because your money is spread across multiple stocks or other assets  You might get a lower return than if you pick a single winning stock
Many funds don’t charge for buying or selling shares in the fund You always pay operating expenses, whether the fund increases or decreases in value

 

How to Invest in Mutual Funds

To start investing in mutual funds, you can buy shares:

  • Directly, usually online, from the investment firm that operates the mutual fund. Some of these firms also operate as fund “supermarkets,” that let you buy funds from other companies.
  • From intermediaries, such as financial planners or brokers.
  • Through retirement plans such as your employer’s 401(k) plan. Many people do this to save for retirement.   

The price of a share in the mutual fund is based on the fund’s “net asset value” (NAV), which is the total value of the securities in the portfolio divided by the number of the fund's shares. This price can go up or down, based on the value of the securities in the fund at the end of each business day. If the price goes up, the value of your investment increases. If the price falls, your investment shrinks. 

 

One convenient aspect of mutual funds is that you can invest in dollar amounts that work for you, rather than having to buy a specific number of shares. Some funds require an initial investment of several thousand dollars, but after that you may be able to add smaller amounts, perhaps as small as $100 at a time. You may also be able to set up automatic regular payments – say, monthly – that can be even smaller.

 

Mutual Fund Fees Matter

All mutual funds charge fees. There are two main types:

  • Loads. Some funds charge sales fees or commissions, called loads, when you buy or sell shares in the fund. Funds that don’t charge these fees are called “no-load” funds.
  • Expense ratios. These represent the cost of managing the fund during the year. All funds charge these fees, generally as a percentage of the amount invested. The expense ratio can vary widely, from less than 0.1% to 2% or more. 

A fund with high fees must perform better than a low-cost fund to generate the same return on your investment. Even small differences in fees can mean a big difference to how much your investments grow over time, according to the SEC. For example, if you invested $10,000 in a fund with a 10% annual return and an expense ratio of 1.5%, your money would grow to roughly $49,725 after 20 years. If you invested in a fund with the same performance and expenses of 0.5%, you would end up with $60,858 – earning more than $11,000 extra.3 

 

The good news is that fees have fallen over time. The average expense ratio for mutual funds that invest in stocks dropped from 1% in 2003 to 0.55% in 2018, according to an investment industry association.4

 

Choosing Which Mutual Funds to Invest In

There’s an extraordinary variety of mutual funds to choose from – more than 9,600 in 2018, according to Statista. They vary widely in their performance, investment approach, and level of risk, so research carefully before you invest. The SEC recommends reading the “prospectus” that each fund is legally required to produce, which describes the fund’s investment objectives, risks, performance, and expenses.   

 

Common types of funds include:

  • Stock or equity funds. This is the biggest category of mutual funds. Equity funds buy stocks of publicly traded companies. Some funds aim for very high financial returns with more risk, while others are more conservative. Funds may buy a broad spread of different stocks, or they may focus on specific industry sectors such as technology or healthcare, regions such as U.S. domestic or international, or sizes of company.
  • Bond funds. Instead of buying stocks, these funds invest in bonds, which are essentially loans to corporations or governments who pay you back at a fixed rate of return. Some experts say that bond funds generally have less potential for growth than equity funds, but also have lower risk.5
  • Index funds. Increasingly popular in recent years, these “passively managed” funds simply track the performance of a specific stock or bond index, such as the S&P 500 index of the 500 largest U.S. publicly traded companies. To do this, the fund buys stock in the companies included in the index.
  • Balanced funds. Invest in a mixture of stocks, bonds, and other assets. They include target date funds, which change their asset mix over time, usually with a particular goal in mind. For example, a fund designed to help you save for retirement at a specific target date may gradually shift its investment mix from higher-growth, higher-risk stocks to lower-growth, less-risky bonds.
  • Money market funds. Buy specific types of low-risk assets such as short-term U.S. Treasury bills. Don’t confuse them with money market accounts, which hold cash.

 

Active vs Passive Money Management

Some funds take an active money management approach: They aim to beat the stock market by picking winners and/or frequently buying and selling stocks to take advantage of short-term price fluctuations. These funds generally have higher fees. In contrast, index funds use a passive money management approach, which generally results in much lower fees. Instead of putting effort into picking winners, they simply adjust their stock holdings automatically when companies enter or leave the index they track. 

 

Largely because of the lower fees, passively managed funds such as index funds have become increasingly popular. During 2019, they attracted more investment than actively managed funds for the first time, according to experts.6

 

How Do You Make Money from a Mutual Fund?

You can earn money from a mutual fund in several ways, depending on the fund:

  • Dividend or interest payments. Funds may earn money from dividends paid on their stock holdings, or interest on bonds. Depending on the fund and your preference, the fund’s provider may either reinvest that money in the fund or send it to you.
  • Capital gains. If a fund sells stocks at a higher price than when it bought them, it makes money termed capital gains, and reinvests or distributes it to shareholders.
  • Increased fund share price. If the fund’s share price increases – for example, if the stocks held by the fund rise in value – the value of your investment will increase.

 

The Takeaway

Mutual funds can provide a convenient way to invest your money in stocks or other financial assets that may help your money grow, without spending time researching and buying individual stocks. Still, you should research each mutual fund carefully before you invest, because there’s generally some risk involved.

Mike Faden

Mike Faden has covered business and technology issues for more than 30 years as a writer, consultant and analyst for media brands, market-research firms, startups and established corporations.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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