Contents
What’s an Investment?
Risk and Risk Tolerance
Asset Allocation and Diversification
Should You Be Investing?
How to Get Started Investing
How to Invest in Stocks
How to Invest in Bonds
How to Invest in Mutual Funds
How to Invest in ETFs
Investing and Taxes
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How to Invest in Mutual Funds
A mutual fund is a type of investment that pools money from a group of investors and then invests that money in a specific set of investments, such as stocks or bonds. Mutual fund companies, such as Vanguard, Fidelity, and T. Rowe Price, create mutual funds and employ professional fund managers to oversee and adjust each mutual fund’s holdings as market conditions change.
When you buy a mutual fund, you buy shares, each of which represents a fraction of the investments owned by the mutual fund. For instance, if a fund owns 50 stocks, and you own several dozen shares of the mutual fund, you own a fractional share of each of those 50 stocks. When the overall value of the fund’s holdings increases or decreases, so does the value of your shares.
How to Buy and Sell Mutual Funds
On the stock markets, shares of stocks change hands constantly throughout the standard trading day. Buying and selling mutual funds works differently: though you can place orders to buy and sell funds through brokers or brokerages at any time during the trading day, your orders are not filled until trading ends at 4:00 p.m. each day. This delay occurs because each mutual fund must tally up the value of its
underlying securities—the net asset value (NAV)—at the end of each day to determine the fund’s new share price.
Mutual Fund Expense Ratios
Running a mutual fund costs money. Expenses include everything from fund manager salaries to office supplies to transaction costs for buying and selling securities. A fund’s expense ratio is an annual fee, expressed as a percentage, that’s charged to shareholders to cover the fund’s overall operating expenses. Many investors make the mistake of disregarding expense ratios because they seem so small—usually 0.15–2.00% or so. This mistake can cost thousands of dollars over time.
How Expense Ratios Impact Fund Returns
Consider the impact of expense ratios on $10,000 invested for 20 years in the two funds below:
Fund A |
Fund B |
|||
Expense ratio |
0.18% |
1.50% |
||
Annual rate of return |
10% |
10% |
||
Value after 20 years |
$65,107.17 |
$51,120.46 |
||
Expenses paid |
$1,010.11 |
$7,256.55 |
Though the ratios differ by only 1.32%, over 20 years that difference adds up to $6,246.44 in additional fees.
Active Funds vs. Passive (Index) Funds
All mutual funds break down into one of two types: actively managed funds and passively managed funds.
- Actively managed funds: Managers of actively managed funds use their expertise and research to hand-pick the fund’s investments on an ongoing, “active“ basis in order to maximize returns.
- Passively managed funds: Passively managed funds, or index funds, attempt to mimic the performance of a particular market index, a group of investments that serves as a benchmark for the performance of other investments. For instance, an index fund that mirrors the S&P 500 index will hold most of the stocks included in the S&P 500 index in the same proportion in which they compose the actual index.
Actively managed funds tend to have higher expense ratios than index funds: the average expense ratio for an actively
managed fund is 1.50%, while most index funds have
expense ratios below 0.25%.
Why Most Actively Managed Funds Aren’t Worth It
A number of studies have shown that during periods of at least five years, only 33% of actively managed funds that
invest in securities like those in the S&P 500 actually beat the performance of the S&P 500 index. This makes index funds the best bet for most individual mutual fund investors.
Load Funds vs. No-Load Funds
Loads are fees that mutual funds charge investors in addition to standard mutual fund fees, such as expense ratios. Load funds charge these fees, whereas no-load funds don’t. Though you might think that load funds could get away with charging additional fees only if they outperformed no-load funds, studies have shown that most load funds both
underperform no-load funds and cost more in fees along the way. With thousands of inexpensive no-load funds
available, there’s just no good reason to buy load funds.
The Main Types of Mutual Funds
The three major categories of mutual funds are stock funds, bond funds, and money market funds. Additionally, balanced funds include both stocks and bonds in one fund, while REIT funds invest in real estate companies.
Stock Funds
Stock funds, or equity funds, invest in the stocks of publicly traded companies. These funds are further classified by market capitalization (market cap), investment style, sector, and geographic location. Some funds combine several classifications within one fund.
- Market cap: Stock funds often focus on buying companies whose market caps all fall within one of the five market cap ranges (micro-, small-, mid-, large-, and mega-cap). In general, the smaller the market cap, the greater the risk and potential reward.
- Investment style: The term style in the context of stock mutual funds refers to whether the fund invests in growth or value stocks. Blend funds invest in a mix of growth and value stocks.
- Sector: Sector funds invest solely in companies that do business in a particular industry, such as energy, healthcare, or technology.
- Geographic location: Some stock funds invest only in businesses based in particular regions, such as Latin America, Europe, or even specific countries.
Bond Funds
Bond funds own baskets of corporate or government bonds. If you buy a bond fund, you get the predictable performance and returns of the underlying bonds that the fund owns, but without the hassle of buying individual bonds. What you don’t get, though, is a guaranteed return of your principal. Bond funds break down into a variety of subcategories based on term, issuer, tax status, and region.
- Term: Some bond funds buy only short-term, intermediate-term, or long-term bonds.
- Issuer: Some bond funds buy government bonds, municipal bonds, or corporate bonds.
- Tax status: Taxable bond funds hold bonds that require owners to pay taxes on interest income; tax-exempt funds hold bonds that pay tax-free interest. Taxable bond funds, however, pay higher interest rates than tax-exempt bond funds.
- Region: Region bond funds, or foreign bond funds, buy bonds issued by governments or corporations in specific regions or countries other than the United States. Investors tend to favor foreign bond funds that focus on regions (or countries) with stable political and economic climates, such as Europe and Japan.
Fund companies often offer bond funds that combine two or more of these classifications. For instance, a long-term government bond fund would own bonds issued by federal or state governments with terms of 10 years or more.
Money Market Funds
Money market funds invest in short-term debt instruments that pay interest. Fund companies often recommend these funds to clients as an alternative to savings accounts, since money market funds:
- Are nearly as risk-free as savings accounts
- Offer higher interest rates than savings accounts
Though money market funds are very safe, they’re not a great place to keep money long term if you intend to grow your principal.
Balanced Funds
Balanced funds invest in a mix of stocks and bonds. Buying such a fund can be a simple, convenient way to build a balanced investment portfolio with just one holding.
REIT Funds
REITs (real estate investment trusts) are corporations that develop and/or manage real estate properties. REIT funds are mutual funds that invest exclusively in the stocks of these corporations. Investors buy REITs as a way of including real estate in their investment portfolios without actually having to own real estate property.
Should You Invest in Mutual Funds?
All investors face the question of whether to buy individual investments, such as stocks and bonds, or to buy mutual funds. There are three major reasons why investing in mutual funds is a better choice for many investors.
- Increased diversification and reduced risk: Mutual funds allow you to build a thoroughly diverse investment portfolio and reduce the risk by owning just a few different types of funds.
- Cost: Whereas you pay commissions and other transaction costs every time you buy or sell individual stocks and bonds, you can buy most mutual funds without incurring any transaction costs at all.
- Convenience: To build a portfolio of individual stocks and bonds as diverse as you can create through mutual funds, you’d need to spend hours researching and monitoring your holdings on a weekly basis.
Mutual Funds vs. ETFs
Once you’ve decided to buy mutual funds rather than
individual stocks or bonds, there’s another key question you need to ask before you buy a mutual fund: should you buy a comparable ETF instead? (For help answering that question and for more on ETFs, see How to Invest in ETFs.)
How to Decide Which Mutual Funds to Buy
The two most important factors to consider before you buy a mutual fund are fees and returns. Only one statistic among the dozens of figures that mutual fund companies publish annually will tell you what you need to know about a fund’s fees and performance: total return after taxes and expenses. This statistic shows the return that fundholders have made on their investment after all taxes and expenses are taken into account. When researching a fund’s total return after taxes and expenses, be sure to heed these two guidelines as well:
- Avoid “hot” funds: Consider the fund’s total return after taxes and expenses over the past 5–10 years, not just the past year or so. And remember that past performance is no guarantee of future results.
- Look for low expense ratios: Never buy an index fund with an expense ratio above 0.50% or an actively managed fund with an expense ratio above 1.50%.
| Acknowledgments & Disclaimer |
