Investing in mutual funds is something almost everyone has heard of, but which many new investors don’t fully understand.
In this quick guide on how to invest in mutual funds, we are going to answer the fundamental questions about what mutual funds are, who should invest in them, and some of the pros and cons of doing so.
By the end of this mutual funds guide, you will be able to make a decision on whether or not investing in them is right for you.
What is a Mutual Fund?
Individual investors simply don’t have the buying power of big banks and corporations, and so mutual funds are formed when lots of smaller investors pool their resources and hire a professional portfolio manager to invest and manage them.
Typically, they buy different stocks, bonds, and other securities in alignment with the fund’s prospectus.
For example, most funds will have an established risk level and will either invest in or avoid securities based on this, among other factors.
When the profits come in, each investor in the fund gets his or her share, minus the fees and costs of running the fund, which are known as the mutual fund expense ratio.
Types of Mutual Funds
As we hinted at earlier, mutual funds have their own characteristics, such as their risk profile. In this section we will outline the main types of mutual fund and what defines them.
Money Market Funds – These are typically very low-risk funds which consist of high-quality, short-term investments issued by US corporations as well as federal, state, and local governments. Remember, though, that low risk never means no risk, and no mutual fund is 100% foolproof.
Bond Funds – Bond funds are a little riskier than money market funds, but the flipside is the return is high, too. These typically pay dividends after an agreed period of time and are based on the debt taken by companies and governments.
Stock Funds – As the name suggests, these are mutual funds which primarily invest in stocks. They are also sometimes known as equity securities. Naturally, how well they perform depends on the overall stock market as a whole.
Target Date Funds – Also known as a dynamic risk or age-based fund, these are mutual funds with a target date in mind, which tend to become more conservative as the target date approaches. Many people invest in these for retirement, with the date of said retirement being the target date. These typically hold a mix of stocks, bonds, and other securities.
Mutual Funds Fees
When considering any mutual fund it is important to consider the fees, as even a small percentage could make a huge difference over the long term.
Mutual funds are referred to as either ‘load’ or ‘no load’. This means it either pays a commission or does not.
Funds which make use of an investment professional will be ‘load’ funds most of the time.
That said, no load funds are not free. There are other associated fees and expenses including fund fees, management fees, and overall fund running expenses.
All of the expenses associated with a given fund are disclosed in the annual prospectus. Also be aware that chasing in too early could incur a fee known as a redemption fee or short-term trading fee.
It is essential to check and understand all fees before investing in any mutual fund.
Benefits and Risks of Mutual Funds
Investment is a game of risk and reward, and mutual funds are no exception. Let’s take a look at the benefits first, then assess the risk of mutual fund trading.
Dividend Payments – Depending on the type of fund, dividends on stocks or interest on bonds will be paid out to investors. These are, of course, minus expenses, but the shareholders still receive the lion’s share.
Capital Gains Distributions – Since all securities fluctuate in value, there is a chance that anything the fund has invested in will increase in value. If that security is sold, the capital gains will be distributed at the end of the year to investors. Of course, some capital losses are possible, too.
Increased NAV – If the overall value of a fund’s portfolio increases, then the value of the fund and its shares also. This means that your investment value increases as a whole.
Potential Losses – Nothing is guaranteed, and as market conditions and the economy change, a profitable fund today could change in the future. It is possible to actually lose money and even wipe out in a mutual fund.
Diversification – Investing in one fund is by nature risky. You have no doubt heard the old saying ‘Don’t put all of your eggs in one basket’. That applies to mutual funds investing as much as anything else, and you should take care to diversify in case of a crash or downturn.
The Gambler’s Fallacy – There is an error in human thinking known as the gambler’s fallacy, in which we believe that past performance suggests how future performance will go. This is simply untrue, and a mutual fund which has grown exponentially over the past few years won’t necessarily continue to do so in the future.
Did you know: Every mutual fund is required to file a prospectus and regular shareholder reports with the SEC. These provide a wealth of information about the funds and can help you accurately weigh up the benefits and risks of investing using first-hand, detailed information. Definitely look at these before jumping in and investing in any fund.
How to Buy and Sell Mutual Funds
There is no surefire way to buy mutual funds without risk, but there is definitely a process which can reduce that risk and lead to better investing decisions. It is as follows:
First, narrow down your options by screening out funds which aren’t within your risk parameters or which don’t meet your individual investment needs. There are many funds out there, so consider using a screener tool to help you weed out the unsuitable funds.
Consider the amount of time you want to invest for and pay attention to a fund’s sale fees. These can take a hefty chunk out of your profits, so read the terms carefully and find out what the minimum investment timeframe is.
Then, do your fundamental research. How has the fund been performing? Is the management up to scratch? How are the firms the fund is invested in doing and what is their future likely to be?
After that, consider the minimum investment amounts. How much do you have to invest and is there an annual minimum? If so, make sure you can afford to keep up the investment requirements. At this stage, you also need to consider the fees.
Consider how the mutual fund is traded. Can you buy directly from the mutual fund company for dollar amounts, or do you need the help of a broker? If so, what are the broker’s fees?
Also take a look at the transaction fees. It is possible to purchase funds from ‘fund supermarkets’ and the like, but these often incur their own fees. Weigh the benefits of convenience with the true costs and decide how to best proceed.
Finally, it is time to buy. You can do this via telephone, online, or in person if you are dealing with a financial representative. Let them know how much you want to invest and which fund you want to buy into. You should always be given the funds closing price on the day you place the order.
Mutual funds are an extremely popular investment vehicle which offer a way to invest for the future to investors with all sorts of preference and appetite for risk.
While they are often seen as an ideal way to take care of your retirement, no mutual fund is risk-free, and no money manager is all-knowing. Don’t make the mistake of investing in a fund and taking your eye off the ball. Ultimately, you are still responsible for your own investments.
As you can see, there is lots to consider before investing in mutual funds. Consider the above and think carefully before proceeding.