How To Invest In Mutual Funds - A Detailed Guide
Today’s investment culture is very different from what it used to be in the past. Gone are the days when only the wealthy members of our society could afford to invest.
These days, many people show genuine interest in investing, and there are many more investors with modest incomes than ever before.
People do not necessarily have to have an enormous amount of money stashed before they can start investing: modern investors often start small and build their portfolio to where they want it to be.
Despite the numerous investment opportunities at our disposal today, such as stocks, real estate, tech, bonds, and cryptocurrencies, an investor’s portfolio will not be complete without mutual funds.
Due to their affordability, many investment journeys start by investing in mutual funds before joining the bigger leagues.
Some of us may have heard many discussions about mutual funds without knowing what they really are. In this article, we will be breaking down the concept and telling you how to invest in mutual funds.
What Are Mutual Funds?
To put it simply, a mutual fund is a type of investment where an asset management company gathers money from several people (investors) and invests it by buying securities. These securities could include stocks, money market instruments, bonds, equities, or other assets.
Mutual funds offer small-scale and individual investors an opportunity to own a diversified portfolio of different investments.
How Do Mutual Funds Work?
Before starting to invest, it is always advisable to have a proper understanding of how your chosen investment works.
You do not want to put your hard-earned funds into something that doesn’t make sense to you, and it’s little use knowing how to buy mutual funds if you don’t understand how the entire system works.
The concept of mutual funds may sound a bit complicated at first, but when you wrap your head around how it works, it becomes much simpler.
As stated before, this type of investment involves asset management or mutual fund companies pooling money from different investors and purchasing various assets, giving them a diversified portfolio.
In mutual funds, the investors do not own the securities directly, but they possess a percentage of shares of the mutual fund company that purchased these diverse financial assets. The companies aim to gain returns from the securities and share an agreed percentage with the investors.
This means that investors share in the gains or losses of the company, so when the company makes profits from the sales of their securities, they distribute it to all the investors, and when they make losses, they all bear the brunt.
Therefore, an investor buying a mutual fund from a company means that they are buying the potential value of the company’s investment portfolio. Thus, the question of how much to invest in mutual funds depends on how comfortable you are with the company’s investment choices.
As a mutual funds investor, you can earn money from mutual funds through any of the following ways:
- Capital gain: These are returns gained when the company sells a security at a higher price than what they bought it for. Say, for instance, it purchased a million dollars worth of stocks when the price was about $100 per share and then sold these same stocks when their value increased to about $1,000 per share. You can imagine the profits or gains the company would have made from such sales. This is referred to as the capital gain, and it is usually distributed to the investors accordingly. It is a common way for a mutual funds investor to gain money from an asset management company.
- Dividends: Another way investors get their income is through dividends or interests acquired from the securities in the mutual funds’ portfolio. These dividends or interests are distributed proportionately to the investors.
- Net Asset Value (NAV): The Net Asset Value of a mutual fund refers to the market value per share of the mutual fund. To calculate the NAV of a fund, you will divide the total value of all the securities in the fund by the number of outstanding shares. This is another way investors get income from their funds by selling off their high-valued fund’s shares.
To ensure that the asset management company makes more gains than losses, they diversify their investment portfolio so that in case they bear a loss on an asset or security, it will not significantly affect their entire asset portfolio.
Why Do People Buy Mutual Funds?
Different people have different reasons for investing in mutual funds, but we’ve listed the most common ones below:
- Affordability: Mutual funds investments have won the hearts of many because of their affordability. You don’t need an enormous amount of money to invest in mutual funds, which makes it pretty easy for just about anyone to invest, compared to other forms of investments.
- Diversification: Mutual funds offer a diverse portfolio for investors because they get to invest in a variety of securities without having to buy them individually. Imagine having a big box of mixed chocolates or candies instead of just one flavor to choose from. One of the most significant benefits of mutual funds and this type of diversification is that when a particular set of stocks, bonds, or securities is doing poorly, the gains from others can make up for it.
- Professional management: Many people love that with mutual funds, the bulk of the work in choosing the best securities to invest in is taken off their shoulders.
- Mutual funds are professionally managed by the fund managers, and as such, an investor does not have to think about researching the best type of securities to invest in.
- Liquidity: Every investor wants to have the option to liquidate their assets easily when necessary, and mutual funds give you precisely that. As an investor, you can liquidate your assets for their current net asset value whenever you need to. For most people, this is a huge plus.
Active vs. Passive Mutual Funds
Mutual funds can be broadly categorized into passively and actively managed funds, irrespective of their type.
Active Mutual Funds
These types of funds are actively managed by professional fund managers. Here, the investor pays a management fee of about 0.5% to 1% since the fund managers will be working more to ensure that the investors make the most of the stocks they buy.
Actively managed funds mostly (but not always) do better than passive ones because the managers do their due diligence and research the industry thoroughly before buying or selling their stocks. The aim is to predict the performance of these companies and make their choices based on complex analyses.
Still, considering there’s no guarantee that these investments will outperform passive funds, there’s a risk of making less profit because you’ll be paying higher fees.
Passive Mutual Funds
These types of funds are not actively managed by professional fund managers, and so they do not require a high management fee. Passive funds tend to track and imitate the asset performance of market indexes such as the S&P 500.
As such, when the market index performs well, the funds do too. Since they do not involve certain trade decisions or in-depth research and analyses to be made by the managers, the management fee for passive funds is usually much lower than actively managed funds (about 0.06% as of 2020).
Examples of passive funds include index funds and exchange-traded funds (ETFs).
Types Of Mutual Funds
Below are the various types of mutual funds you can invest in:
Equity or Stock Funds
Equity funds mainly focus on investing in stocks and usually yield the most profits. That said, they are considered high-risk investments.
These types of funds are heavily influenced by the stock market’s performance, meaning that when it is doing well, the investors get higher returns and vice versa.
Stocks funds can also be broken into smaller subcategories based on their characteristics.
For example, income funds focus on stocks with regular dividends, index funds track and imitate the market index, growth funds are all about stocks with the potential to yield higher gains in the future, etc.
Fixed Income Funds
Fixed income stocks, otherwise known as bond funds, invest in debt securities such as bonds. These could be either government bonds or debentures coming from the private sector.
Fixed income funds are classified as moderate or medium-risk investments, and as such, the returns are not as high as with equity funds.
The government bond index is usually used as a yardstick to determine the performance of most debt securities.
Money Market Funds
Money market funds invest in safer, highly liquid, short-term securities like treasury bills, cash, cash equivalents, etc. Money market funds are low-risk investments, and investors can ensure that their principal capital is safe.
However, being low risk also means that they do not yield significant returns, either. Investors barely experience losses with money market funds, but significant gains are very rare, too.
Balanced Mutual Funds
Balanced mutual funds are also referred to as asset allocation funds. They are funds that simultaneously invest in different classes or a hybrid of asset types. A portfolio of a balanced mutual fund can be made up of bonds, treasury bills, stocks, and even other mutual funds, in a particular ratio.
This helps diversify it and balances the risk as well. A target-date fund is an example of a balanced mutual fund. It is ideal for investors with a retirement date in mind.
It follows a strategy that automatically reallocates funds to safer investments as the retirement date draws near.
Mutual Fund Fees
Having grasped the basics, you may now be wondering how to invest in a mutual fund and what it will cost. By now, you already understand that mutual funds can either be actively managed or passively managed.
Regardless of which one you choose, the asset management company will charge you a fee for running and managing your funds. These fees could be a certain percentage of your portfolio or a fixed percentage of every investment you make.
Also, bear in mind that some other costs may arise in the process.
Based on the costs, mutual funds can be classified as load funds or no-load funds.
Load funds reward a commission to the broker for every fund they sell to an investor, and the investor bears this cost. No-load funds do not pay any commission to the broker for the fund sales and are thus preferable for investors.
How To Invest In Mutual Funds
Here are a few guidelines on proper investment strategies:
Identify Your Investment Goal
Before you start investing in mutual funds, you need to have a clear picture of what you hope to achieve with your investments. Are you pursuing a long-term goal such as retirement or a short-term one like buying a car?
What is your investment budget? Would you like to invest in low-risk, medium-risk, or high-risk funds? These are some of the questions whose answers can help you write out a detailed plan of what you want to achieve with your investments.
Pick an Investment Strategy
So now that you have figured out what you want to achieve with your investment, the next thing is to figure out how you intend to achieve your goals.
What percentage of your income do you intend to invest monthly? Are you a young investor willing to take higher risks? Or are you close to your retirement and would prefer a more conservative approach to achieving your goals?
Do you want your funds to be actively or passively managed?
A proper strategy based on your goals will take you a long way towards making better investments. You’ll also want consistency and a clear idea of what you are doing and why even when it requires sudden changes in your investment portfolio.
Pick a Mutual Fund Type To Invest In
After choosing a strategy, next, you want to decide on the type of mutual funds to invest in.
Before choosing a fund type, you need to make sure that it aligns with the goals you hope to achieve with your investment. Depending on your preference, you could choose a fund that invests in stocks, bonds, treasury bills, or other debt securities.
You also want to find out the load fees, commissions, or management charges that could be associated with the fund type you decide to go for so you know what to expect.
Seek a Financial Advisor
You can never go wrong with getting a professional to help you analyze your goals and strategies and guide you through the investment process. Advisors are of great help to newer investors who can feel overwhelmed by all of the available options.
If you can not afford the services of a human financial advisor, you could look up some robo-advisors online and save a fair bit of money.
Choose the Most Suitable Broker
Now that you have a goal, a strategy, knowledge of the mutual fund you want to invest in, and possibly the guidance of a professional, the next thing you want to do is choose the most suitable broker or company for your investments.
Assuming you do not already work for a company sponsoring a retirement plan for you as one of the employment benefits, you will need to find a suitable broker and open a brokerage account on your own.
Most brokerages have varied plans suitable for different goals and mutual fund types. So whether you want to invest in stock funds, bond funds, money market funds, or balanced funds, you will find something easily.
Before opening your investment account, remember to pay attention to and understand the fees, charges, or commissions that the broker may require.
Diversify Your Portfolio
The importance of portfolio diversification can not be overemphasized. A diversified portfolio balances your risks while giving you steady returns as well. It is never wise to put all of your eggs in one basket.
Have an Exit Strategy
Whether your goals are long or short-term, eventually, you will need to access the gains of your investments. It’s essential to have a backup plan and know what’s required to get out of the investment game, ideally with a hefty profit in tow.
Pros and Cons Of Mutual Funds Investments
As good as investing in mutual funds sounds, it’s not a worry-free gateway to untold riches by any means. Below we’ve compiled some of the biggest pros and cons of investing in mutual funds:
- Ease of investment: Apart from the research required to find out the best type of mutual fund to invest in, an investor does not necessarily have to do much. The fund managers are the ones that do the bulk of the work. For the most part, you can sit back and watch your investments grow.
- Affordability: With mutual funds, you do not need to have a lot of money saved up before starting your investment journey: with a stable income stream, you can start small and grow your portfolio with time. While some funds may require you to start with anywhere from $500 to $4,000, others do not have a specific minimum investment amount. This makes mutual funds affordable for anyone that wants to invest.
- Diversification: Mutual funds come with the advantage of diversifying your investment, as one fund could give you access to about a hundred stocks or bonds, depending on the fund type you invest in. Diversification also helps you to reduce your investment risk.
- Liquidity: You can easily trade your funds for cash in a matter of a few days if the need arises, which can be very handy if you need to bail out or have urgent costs that need to be covered.
- Transparency: With mutual funds, you get a thorough breakdown of your investment portfolio, and you are also updated from time to time about its progress. This makes the investment process very transparent.
- Professional management: Your funds are managed by professionals, so you know they are in good hands. Nobody can guarantee you anything in this industry, but experienced brokers can give you a sense of security you wouldn’t have if you just dabbled by yourself.
- Fees: These are inevitable because having a professional manage your portfolio comes with a price. The cost will vary depending on whether your funds are actively or passively managed. Sometimes, other charges or commissions may pop up, too, depending on your broker.
- Lack of Investment Control: With mutual funds, you do not have direct control over the investments other than which mutual funds to invest in. This is because you have fund managers that make financial investment decisions on your behalf. You might not get consulted before the manager makes certain decisions, as their role is to grow your portfolio the best way they can, based on their research and analyses.
Conclusion: Are Mutual Funds Worth It?
Generally speaking, mutual funds investments are beneficial to most people, and millions of people have invested in them successfully. That said, just like every investment, there is always an element of risk, and typically the greater it is, the greater the potential rewards will be.
How you feel about risk and whether you can pick a good mutual fund to invest into will ultimately determine whether such investments are worthwhile for you or not.
What is a mutual fund?
A mutual fund is a type of investment where an asset management company gathers money from several people (investors) and invests it by buying securities. This means that the company helps investors invest their money and gives them returns on their investments.
How can I invest in mutual funds online?
Thanks to technological advancements, opening a mutual funds account online is as easy as logging onto the website of an investment company or downloading an investment app on your mobile device and opening an account. Once you fill in your correct details and set up your account, you are good to go.
How do mutual funds work?
In mutual funds, the investors do not directly own the securities, but they hold a percentage of shares of the mutual fund company that purchases these diverse financial assets. So when the company makes gains from their investments, they share the returns with their investors.
What mutual fund should I invest in?
There are different types of mutual funds you can invest in based on your risk tolerance or preference: equity funds, money market funds, balanced funds, fixed-income funds, etc. All of these have their benefits and downsides, so before you determine the exact fund to invest in, you will need to find the fund type that best aligns with your investment goals.
Are mutual funds safe?
Mutual funds are safe investments because of the diversification they offer. This helps you balance your risks while still getting your returns. So even when a particular stock in your fund is not performing well, the returns from the other stocks in your portfolio can cover up the gap.
How can I invest in mutual funds?
In this article, we have broken down the concept and given details on how to invest in mutual funds. Below is a quick refresher:
- Identify your investment goals.
- Pick an investment strategy.
- Pick a mutual fund type to invest in.
- Seek a financial advisor.
- Choose the most suitable broker and open an investment account.
- Diversify your portfolio.
- Have an exit strategy.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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