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If you're just getting started with investing, it's important to develop a strategy and understand what you're investing in. Mutual funds are an easier way to diversify your portfolio since they pool money from many investors and place it in a variety of securities. As a shareholder of the fund, you'll benefit from the growth and dividends of the fund's investments.
But not all mutual funds are created equal. While some specialize in stocks, others focus on fixed income, money market, indexes and more.
Depending on your investment goals, it may be a good idea to invest in multiple types of funds. As you try to determine how to invest your money, here's what you should know about the more common types of mutual funds out there and how to decide which ones might be best for you.
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Different Types of Mutual Funds
As you consider how to invest your money, mutual funds can be a great option, particularly if you're a beginner. Mutual funds don't tie up your investment in a single company's stock: They invest in many—sometimes hundreds—of companies, which can help mitigate some of the risk involved in investing.
Here are some of the most common types of mutual funds and how they work.
1. Equity Funds
Equity mutual funds invest in stocks. Under this umbrella, there are several different types of funds. An equity fund can fall into one or more of these categories based on the type of stocks they invest in:
- U.S. equity funds: Only companies listed on U.S. stock exchanges
- Foreign equity funds: Only companies listed on foreign stock exchanges
- Large cap: Companies with $10 billion or more in market capitalization, which is the total value of all of the company's shares
- Mid cap: Companies with a market capitalization of $2 billion to $10 billion
- Small cap: Companies with $300 million to $2 billion in market capitalization.
- Growth: Companies that invest heavily in expanding their business and have the potential for significant growth in the near term
- Value: Companies whose stocks are undervalued based on market analysis
- Income: Companies that offer high dividend yields on their stocks.
You can also find equity mutual funds that offer a blend of some of these categories, which may provide a better fit for your investment strategy. Equity funds typically have a relatively high return compared to some other options, but that also translates to more risk.
2. Bond Funds
These mutual funds invest in various bonds, which can provide a fixed income similar to dividends in an equity income fund. Potential options include Treasury bonds, corporate bonds and municipal bonds.
Bond funds are typically less risky than other types of mutual funds, but they tend to offer lower returns.
3. Index Funds
Index funds are set up to imitate the performance of specific indexes, such as the S&P 500 or Russell stock indexes, the S&P 500 bond index or others. Because they are passively managed based on the index they track, index funds provide a low-cost alternative to actively managed funds in which managers regularly research and choose the fund's securities.
Performance can vary depending on the index the mutual fund is tracking.
4. Asset Allocation Funds
This type of mutual fund invests in more than one asset class, so you may get a mix of stocks, bonds and cash equivalents, among other options. Return potential can vary depending on the mix of assets and how much weight the fund gives each.
5. Target-Date Funds
Target-date mutual funds invest in a mix of asset classes based on a specific time horizon. For example, if you're planning to retire in 30 years, you'd pick a fund that matures around that time. The fund may invest more aggressively at first, then slowly get more conservative as you near your retirement age.
Target-date funds are beneficial for people who want to invest for retirement but don't want to deal with strategizing asset accumulation and capital preservation throughout the process.
6. Money Market Funds
These mutual funds invest in cash equivalents, such as certificates of deposit and U.S. Treasury bills. They carry much less risk than most types of mutual funds, but they also typically provide a very low return.
Investing in a money market fund can be a good alternative to putting your cash in a savings account, but it won't offer much growth.
7. Specialty Funds
These mutual funds invest in a variety of specialized securities, such as real estate, oil, precious metals and other commodities, cryptocurrencies, socially responsible companies and more. Performance can vary depending on which assets you're investing in.
How to Choose a Mutual Fund
As you research different mutual funds, it's important to know your investment goals and how each option can help you achieve them. It's also important to understand your risk tolerance. While some funds provide the potential for higher returns, that also means more risk.
If you're saving for retirement, you can generally take on more risk early on in the process because you don't have to worry about short-term market fluctuations. At this stage, equity funds, index funds, asset allocation funds, target-date funds and specialty funds may be more appealing.
But if you're planning to retire in the next five years, preserving the capital you've already accumulated is more important, so you may want to gravitate toward bond funds, money market funds and asset allocation funds that prioritize lower-risk securities.
As you compare your options, you'll also want to look at the makeup of the fund and the fees that the fund provider charges, as that will impact your return.
If you're uncertain about which funds to choose, consider investing in more than one. You may also consult with a financial advisor who can help you define your approach.
How to Get Started Investing in Mutual Funds
One way to invest in a mutual fund is to go directly to its provider or a brokerage firm. You'll need to set up an account with the provider or the broker to get started and fund the account with enough cash to purchase the number of shares or fractional shares you want.
You'll then find the ticker symbol for the fund or funds you're interested in and submit a purchase order based on your desired investment amount. Note that, unlike stocks and exchange-traded funds, mutual funds cannot be bought and sold throughout market hours. Rather, purchase orders are executed once a day after the market closes.
You can also invest in mutual funds through a 401(k) plan if your employer offers one or an individual retirement account (IRA). These retirement accounts may offer several different types of mutual funds as possible investment options.