How To Invest in Mutual Funds

A beginner’s guide to mutual fund investing

Fact checked by Vikki Velasquez
Reviewed by David Kindness

Mutual funds are a popular choice for first-time investors. These vehicles offer a simple, accessible, and diversified way to invest. Given the many changes in the U.S. economy, including the steep drop in the number of Americans with defined pension plans, mutual funds are frequently chosen for long-term investing, with a majority—56%—of American households with money in them as of 2024.

Key Takeaways

• Mutual funds are a convenient way for individuals to invest in a diversified portfolio of securities.
• Individuals should define their investment goals and understand their risk tolerance before investing.
• Different types of mutual funds include equity, bond, and balanced funds.

What Is a Mutual Fund?

Mutual funds pool money from many investors to purchase a diversified portfolio of securities, such as stocks and bonds. Established by 1940 legislation, these funds give individuals access to a broader range of assets and the safeguards of professional money management that otherwise would have been too costly to obtain on their own.

Mutual funds offer diversification, spreading investor money across many securities and sectors, reducing their portfolio’s overall risk. Gains in one asset can offset losses in another. Mutual funds also cater to various investment goals and risk tolerances. In 2023, investors chose from over 7,000 U.S. mutual funds.

Mutual funds differ from trading stocks. Stocks are traded throughout the day on stock exchanges, however, mutual fund shares are purchased and sold directly through the mutual fund company or a brokerage firm. Mutual fund orders are typically processed at the end of each trading day, with the price per share determined by the fund’s net asset value (NAV) at the close of the market. Many investors set money aside in mutual funds through their paychecks, some with matching funds from their employer for retirement.

Types of Funds

Equity Funds

Also known as stock funds, equity funds invest in publicly traded companies. Investors commonly evaluate equity funds based on market capitalization, individual investment style, and location of the fund.

• Market capitalization: Large-cap funds invest in companies with a market value exceeding $10 billion, which are ordinarily more established and less volatile. Midcap funds focus on companies worth $2 billion to $10 billion, offering a balance between growth and stability. Small-cap funds invest in companies with a market value below $2 billion, which may have higher growth potential and risk.
• Investment style: Growth funds invest in companies with high growth potential, prioritizing capital appreciation over income through dividends. Value funds seek undervalued stocks believed to be trading below their true worth, aiming to benefit from a potential price increase. Blend funds provide a more balanced approach between the two.
• Geography: Domestic funds focus on stocks of U.S. companies, while international funds invest in stocks outside the U.S. Some funds may also focus on a specific region, such as Europe or Asia. Overseas funds can be subject to additional risks, such as currency fluctuations and political instability.

Bond Funds

Bond funds invest primarily in fixed-income securities, such as corporate, government, and municipal bonds. They aim to provide regular income and add stability to a portfolio. Bond funds can be categorized based on the type of issuer or bonds in which they invest (e.g., government vs. corporate), the credit quality of the issuers (from investment-grade to junk), and the duration of the bonds (from short-term to long-term).

Balanced Funds

Also known as hybrid funds, balanced funds invest in a mix of stocks and bonds to offer a balance of growth and income. The allocation between stocks and bonds depends on the fund’s investment strategy and risk profile, such as 60% in stocks and 40% in bonds. These funds are suitable for investors seeking a single, diversified investment solution.

Money Market Funds

Money market funds invest in short-term, low-risk debt securities, such as Treasury bills, certificates of deposit (CDs), and commercial paper. They aim to maintain a stable value and provide a low-risk, liquid investment option. Money market funds are often used for short-term savings or as a temporary holding place for cash. They are more attractive when interest rates are high since they earn more interest.

Index Funds and Target-Date Funds

Index funds passively track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. If that index performs well, so do the index funds. Target-date funds are designed for investors with a specific retirement date. Many 401(k) plans offer target-date funds that automatically adjust asset allocation, becoming more conservative as the target date approaches. This “set it and forget it” approach is great for investors who want a simple, long-term investment solution.

Specialty Funds

Specialty funds focus on specific investment strategies or asset classes beyond stocks and bonds such as:

• Sector funds invest in companies within a particular industry or sector, such as healthcare, energy, or technology.
• Socially responsible investment (SRI) funds, known as environmental, social, and governance (ESG) funds, invest in companies that meet specific criteria.
• Real estate funds invest in real estate investment trusts or buy their real estate holdings.
• Commodity funds invest in physical commodities like gold, oil, agricultural products, or commodity-linked derivatives.

Note

Mutual fund returns are calculated using total return, including capital appreciation (increase in the fund’s share price) and income distributions (such as dividends or interest). The total return is usually expressed as a percentage change over a specific period, such as one year or five years.

Getting Started

Set Investment Goals and Budget

• Investment objectives: Identify the reasons for investing, such as saving for retirement, buying a home, funding a child’s education, or building wealth.
• Time horizon: Investors must determine how long they plan to invest before they access their funds.
• Risk tolerance: Some investors are comfortable with the potential for higher returns despite increased volatility, while others prefer a more conservative approach.
• Financial situation: Investors should assess current income, expenses, and debts to determine how much they can realistically afford to invest without compromising their financial stability.

Evaluate Fund Choices

Investors can use their brokerage platform or reputable financial websites like Morningstar or Yahoo! Finance to compare funds and read expert analyses. Helpful tools like mutual fund “screeners” help narrow down choices.

• Fund type: Investors should choose funds that match their investment objectives, such as growth, income, or a combination of both.
• Investment style: Choose between actively managed funds that attempt to outperform the market or passively managed index funds that track market performance.
• Expense ratios: Look for funds with low expense ratios, as high annual management costs can eat into returns over time.
• Loads: Be aware of any extra fees with mutual funds. Some funds carry sales charges, known as loads, that can reduce investment returns. Front-end loads are charged when buying shares in the fund, while back-end loads are charged when shares are sold.
• Additional fees: Look for no-load funds to avoid these charges. Additionally, pay attention to other costs, such as redemption fees and 12b-1 fees, which are for marketing and distribution.
• Minimum investment: While some mutual funds do not have a minimum investment to start investing, some may have start costs of $100, $1,000, or more.
• Fund manager experience: To assess the fund manager’s track record, visit the mutual fund company’s website or review the fund’s prospectus.
• Fund size: The fund’s assets under management (AUM) can be found in the fund’s fact sheet or prospectus. A larger AUM suggests that the fund is well-established and has enough money to support the fund.
• Liquidity: Refers to how easily the fund can convert its investments into cash to meet redemption requests. Funds with higher liquidity can accommodate investors coming into and out of the fund.
• Tax implications: If investing in a taxable account, consider tax-efficient funds that minimize turnover and distribute fewer capital gains.

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Open an Investment Account

• Taxable brokerage accounts: Allow individuals to invest in securities, including mutual funds, stocks, and bonds. They can be held as an individual, as a joint account with a spouse or partner, or as a custodial account held on behalf of minor dependents.
• Retirement accounts: Roth IRAs are a tax-exempt retirement account option where you can put dividend-paying mutual funds without triggering taxable events. 401(k) plans and individual retirement accounts (IRAs) offer tax advantages and are designed for long-term investing.
• Education savings accounts: Accounts like 529 plans can help individuals save for future education expenses.

Place Orders and Make Contributions

Once an investment account is set up and funded, investors can start investing in mutual funds. Lump-sum investing involves investing money at once. Many investors allocate part of their paycheck to 401(k) retirement savings.

Another strategy is dollar-cost averaging by investing a fixed amount of money at intervals regardless of market conditions. This approach can help mitigate the impact of market volatility on investments, as investors buy more shares when prices are low and fewer when prices are high.

To order, individuals log into their investment account and select the mutual fund they wish to buy. Specify the amount to invest and submit an order. Mutual fund orders are typically processed at the end of each trading day. The process for selling mutual fund shares is similar. The order is executed at the next available NAV. The proceeds from the sale, minus any applicable fees or taxes, are then credited to an investor’s account.

Important

Mutual fund shares are valued at their net asset value (NAV), calculated by dividing the fund’s total assets minus liabilities by the number of outstanding shares.

Risks and Considerations for Investors

• Managing and Rebalancing: Investors should regularly review their investments’ performance and compare them to relevant benchmarks and peer funds. If a fund consistently underperforms, it may be time to consider selling it and investing in a better-performing alternative. Rebalancing involves selling investments that have become overweighted in your portfolio and buying investments that have become underweighted to bring a portfolio back in line with the target allocation.
• Market Risk: The possibility that the value of a mutual fund’s investments will decline because of factors affecting the overall financial markets. Market risk is inherent in all investments, including mutual funds. When the market experiences a downturn, the value of a mutual fund’s holdings may decrease, resulting in a lower NAV, potentially lowering your returns.
• Inflation: If a mutual fund’s returns do not keep pace with inflation, the real value of the investment may decline. For example, if a mutual fund generates an annual return of 5%, but the inflation rate is 3%, the real return (adjusted for inflation) would be about 2%.
• Cash Drag: The potential negative effect on a mutual fund’s performance because of holding cash or cash equivalents, such as money market instruments or short-term bonds. Mutual funds often keep part of their assets in cash, however, too much cash can drag performance, especially during bull markets, when stocks are appreciating.
• Fee drag: The negative impact of mutual fund fees and expenses on investor returns. If a fund has an expense ratio of 1% and generates a 10% return before fees, the investor’s actual return would be 9% after accounting for the expense ratio.
• Fund-Specific Risks: Mutual funds are subject to risks related to their investment strategies and holdings. Bond funds are exposed to credit risk when fixed-income issuers fail to make interest payments or repay principal when due. Some mutual funds invest in less liquid securities, such as small-cap stocks or emerging market bonds, which can be difficult to sell quickly. Sector or region-specific funds may be more vulnerable to events affecting those particular areas. International funds that invest in foreign securities are subject to currency risk, as fluctuations in exchange rates affect returns.

What Is the Difference Between an Actively-Managed and Passively-Managed Mutual Fund?

Actively managed mutual funds try to beat a benchmark index using professional managers to make investment decisions, typically leading to higher fees. Passively managed funds, like index funds, aim to match the performance of a market index by mirroring its composition and usually have lower fees.

What Is the Difference Between Mutual Funds and ETFs?

Mutual funds and exchange-traded funds (ETFs) are investment vehicles that pool money from many investors to buy a diversified portfolio of securities, such as stocks or bonds. The main difference is that mutual fund shares are bought and sold directly through the fund company at the end of each trading day, while ETF shares are traded on stock exchanges throughout the day like individual stocks.

What Does the Fund’s Prospectus Tell Investors?

Investors can examine the fund’s prospectus which provides detailed information about the fund’s investment objectives, strategies, risks, and fees. Pay close attention to the fund sponsor’s reputation, the managers’ profiles, and the fund’s historical performance—but remember that past performance doesn’t guarantee future results.

What Is Asset Allocation?

Asset allocation, or the distribution of a portfolio’s investments among stocks, bonds, real estate, cash, and other assets, is crucial in building a well-balanced portfolio.

The Bottom Line

Mutual funds are available to buy and sell through brokerage firms or directly from mutual fund companies. As with any investment, investors should understand the risks and considerations involved and make informed decisions based on their circumstances. Individuals can consult a financial advisor who can help develop a personalized investment plan, select suitable mutual funds, and provide ongoing guidance.