What Are Mutual Funds?

man explaining mutual funds to a woman

Mutual funds pool money from investors to invest in a variety of securities, such as stocks and bonds. Investing in mutual funds can instantly diversify your holdings across many different companies and industries. This puts your eggs into different baskets, which can reduce risk if one of your investments underperforms. Here's how mutual funds work, along with their benefits and drawbacks.

How Do Mutual Funds Work?

A mutual fund raises money from investors so it can invest in different securities, with a goal of offering investors a return on their money. When you buy mutual fund shares, you are purchasing an ownership piece of the fund, and those shares entitle you to part of the income and capital gains the fund makes.

Common types of mutual funds include bond funds, stock (equity) funds, money market funds, index funds, balanced funds and target date funds.

  • Bond funds invest in fixed-income debt securities and are essentially a loan from you to a government entity or corporation.
  • Stock funds invest in corporate stocks, which represent partial ownership, or equity, in a company. Stock funds can vary widely in their goals, risk, holdings and investment strategy. Examples of stock funds include international funds, growth funds and sector funds.
  • Money market funds invest in short-term debts that have high liquidity. They usually include U.S. Treasuries and certificates of deposit (CDs) and carry relatively low risk.
  • Index funds invest in companies included in a given stock index, such as the S&P 500 or Nasdaq-100, with the goal of achieving similar returns.
  • Balanced funds, or asset allocation funds, invest in a mix of assets to reduce risk but still provide potential for growth and income. They typically stick to a fixed allocation of stocks and bonds.
  • Target date funds, also called lifecycle funds, are also mixed bags that may invest in stocks, bonds and other securities, and money is invested with a target retirement date in mind. Asset allocation is chosen based on the time until retirement, with risk lessening as the target date approaches.

Although mutual funds are generally used as part of a long-term investing strategy, you can convert your investment into cash if you need to by selling your shares. After shares are sold, you may receive payment within a week. Keep in mind, however, if your funds are part of a retirement account such as a 401(k), you could pay penalties for withdrawing your money early.

Actively Managed vs. Passively Managed Mutual Funds

Some mutual funds are actively managed, while others are passively managed. Actively managed funds are controlled by fund managers who buy and sell fund holdings with the goal of beating the fund's targeted benchmark return, such as the S&P 500 return.

These funds tend to have higher administrative fees than passively managed funds because managers are more involved in making ongoing strategic decisions.

Passively managed funds, such as index funds, usually track a specific index and try to mirror returns of that index. Because fund holdings are chosen automatically and not by a fund manager, passively managed funds tend to have lower management fees.

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Pros and Cons of Investing in Mutual Funds

Before investing in mutual funds, it's important to consider your financial goals and understand the benefits and potential pitfalls. Here's a quick overview:

Benefits of Mutual Funds

  • Returns: While less risky than individual stock investing, mutual funds invest in companies with the goal of earning higher returns than you'd find with a low-risk investment such as a high-yield savings account or CD.
  • Simplicity: Buying mutual funds is a low-effort way to invest that can help grow your portfolio. This can make it convenient for first-time investors or investors who prefer a more hands-off approach to investing.
  • Diversification: Investing in mutual funds may spread your money out across many asset classes, industries and companies. Diversification can help reduce risk because a loss in one area could be balanced by gains in others.
  • Accessibility: You may not need a large sum of money to start investing in mutual funds. For example, Fidelity has no minimum required to invest with certain funds. Vanguard currently requires just $1,000 to start investing in its Vanguard STAR Fund and Vanguard Target Retirement Funds.

Drawbacks of Mutual Funds

  • The cost: There are several costs to consider. If you buy funds through a brokerage, you may be charged a fee or "sales load" to complete the transaction. There may also be operational costs expressed as an expense ratio, which is a percentage of fund assets that goes to various fund expenses each year. An expense ratio of 0.50%, for example, would mean you'd pay $50 for every $10,000 managed. Comparing fees and expense ratios can help you find low-cost investment options.
  • Investing limitations: Trading decisions are up to the fund managers. If you're someone who enjoys buying individual stock or would prefer to have more control over what's in your portfolio, a mutual fund could be limiting.

How to Invest in Mutual Funds

The process of buying mutual funds is pretty straightforward, and much of it can be done online. You'll need to open an investment account, fund it and purchase shares. Here's a more in-depth breakdown of the process:

  1. Choose where to invest. You can buy funds directly from fund management companies or through brokerages, such as TD Ameritrade or E-Trade.
  2. Open an account. After choosing where you'll invest, the next step is opening an investment account. The application to open an account usually involves entering your name, address and Social Security number and filling out an investment profile.
  3. Transfer funds into the account. You'll be asked to transfer money into the account to invest. Usually, you can connect your bank account to move cash, but other options could be setting up a wire transfer or mailing a check.
  4. Choose mutual funds to purchase. The exact process for buying mutual funds can vary. Generally, online there's a "buy" button you can click on the account dashboard. Then you can search a mutual fund's name or symbol and enter how much to invest. Before buying a mutual fund, you should review performance and read through its prospectus, which outlines the fund's goals and objectives.

The Bottom Line

Investing in mutual funds can be a great way to diversify your portfolio, but be sure to review costs carefully. Expense ratios might seem like a small percentage, but they can eat away at your investment earnings over time.

Also, pay close attention to the investment goals of each fund. If you invest in funds with similar holdings, the overlap could be risky if a certain sector or company takes a hit. Speaking with a financial advisor can help you iron out an investing strategy that makes sense for your goals and risk tolerance.

Whenever you decide to make investments, be sure your existing financial obligations are fully covered. Keep an eye on your financial health by monitoring your credit, which you can do for free through Experian.