What are mutual funds? What to know to start investing (2024)

What are mutual funds? What to know to start investing (1)
  • A mutual fund is a portfolio of investments that pools money from investors to purchase stocks, bonds, or other securities.
  • The majority of mutual funds are professionally managed with the aim to outperform the market.
  • Though they come with fees, mutual funds can add value to your portfolio by offering professional management and diversification.
  • Visit Business Insider's Investing Reference library for more stories.

A mutual fund is a type of investment vehicle that pools money from many investors to purchase stocks, bonds, or other securities. Investors who mutually contribute to the fund company become part owners of the fund's portfolio and the income it generates or loses.

"Mutual funds are an easy and well-established way to give everyday investors diversification," says Michael Iachini, vice president and head of manager research for Charles Schwab Investment Advisory. "They are well established since the 1920s, and they have a track record of working for investors."

While mutual funds have been around for decades, investors are increasingly becoming hip to their benefits. In 2020, 45.7% of US households owned mutual funds, compared to just 5.7% in 1980 according to an Investment Company Institute (ICI) survey.

Here's what to know about mutual funds, including how they work, what to watch out for, and how to get started investing in them.

How do mutual funds work?

Generally, mutual funds are actively managed by a fund manager who controls when to buy and sell securities in order to maximize returns and minimize losses. When you buy a mutual fund, you're buying partial ownership of the fund and its assets, meaning its entire portfolio of investments.

This differs from buying an individual stock, where you buy partial ownership directly in a company and manage any subsequent moves yourself (unless you have a financial manager).

The price of a mutual fund is determined by its net asset value (NAV), which takes all of the portfolio's securities into account. It is found by dividing the total value of the fund's assets (cash and securities) by the number of the fund's outstanding shares.

Since a mutual fund's portfolio consists of many securities that change price throughout the day, the NAV is calculated at the end of the market day. Because of this, mutual funds trade only once per day, after the markets close.

Mutual fund fees

You should be aware that mutual funds come with structured fees for active management, which eat into your total profits. A mutual fund will label fees into two main categories:

  • Annual fund operating expenses: A fund's total annual operating expenses include management and transaction fees, which are expressed collectively as the fund's expense ratio. While relatively small, expense ratios can significantly affect a fund's return, especially over time.
  • Shareholder fees: A fund can also come with shareholder fees, which cover commissions regarding buying and selling the fund. Most mutual funds will have a sales charge called a "load," which can be a flat fee or a commission, and occur when you purchase or sell your shares back to the fund.

If you're in the market for a mutual fund, its fees are an important factor to consider. You can find all associated fees outlined in detail in the fund's prospectus.

How to make money investing in mutual funds

You can make money on mutual funds in a few different ways:

  • Dividend payments
: Similar to stocks, a mutual fund can pay out dividends to its investors periodically. They can choose to receive these payouts as cash or to reinvest them in your account.
  • Capital gains
: When an investor sells a fund at a profit, that's known as a capital gain. This gain gets passed off to a fund's shareholders annually.
  • NAV: If your mutual fund's value increases, the price to purchase its shares will also increase. This benefits you if you choose to sell your shares since you would sell at a gain.

What are the pros and cons of mutual funds?

Before you add mutual funds to your portfolio, there are advantages and disadvantages that can help you decide whether they are the right fit for your investment style and goals.

Pros

  • Offers simplicity and peace of mind with professional fund managers.
  • Typically requires a small minimum investment to buy in.
  • Adds diversification to your portfolio with various asset classes and industries held in one fund.
  • Ability to invest with exact dollar amounts versus buying shares of stocks at fluctuating prices.

Cons

  • Professional management fees can be costly.
  • Mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC), so there is the risk of losing money.
  • There's a chance of dilution decreasing the worth of your shares when a successful mutual fund grows too big.
  • You have no control over a fund manager's decisions, which can trigger tax implications like capital gains that add to your taxable income.
  • Since mutual funds trade after markets close, they don't allow for trading during the day and taking immediate advantage of market movements.

Types of mutual funds

Mutual funds aren't hom*ogenous. They are classified into many different types, including the securities they invest in and the investment goals they seek to achieve. Here are seven of the major types:

1. Equity funds

Equity funds invest mostly in stocks and are often categorized by company size and market capitalization. Equity funds can be labeled as growth, value, or blended funds. Growth funds hold shares of companies with potential to outperform the overall market, while value funds are filled with stocks of seemingly undervalued companies. Blended funds mix both growth and value stocks.

2. Bond funds

Bond funds pool investors' money to primarily purchase bonds, from short- to long-term maturities. Some funds include a range of securities including government bonds, corporate bonds, and mortgage-backed securities, while others may focus on a specific part of the bond market.

Bond funds provide quick diversification without buying various bonds individually. Many funds also distribute dividends each month, which you can reinvest.

3. Money market funds

Money market funds are fixed-income mutual funds that invest in short-term debt securities with low credit risk. These funds aim to provide liquidity, maintain a stable share price, and distribute regular income earned on its securities to its investors.

Money market funds are categorized as government, prime, or tax-exempt, depending on the securities held within the fund. Securities often invested in money market funds include short-term US Treasury securities, federal agency notes, certificates of deposit, corporate commercial paper, and municipal agency obligations.

4. Balanced funds

Balanced mutual funds invest in both bonds and stocks, so you get the best of both worlds with steady income and investment growth. Also known as asset allocation funds, these funds typically stick to their original asset mix. If any changes are made, the funds are automatically rebalanced to bring them back to the original allocation.

5. Index funds

Index funds are a type of mutual fund designed to mirror the performance of a particular market index, like the S&P 500 or the Dow Jones Industrial Average. Because index funds are built to match the performance of the target index, they are passively managed investments. This means they require less research and trading from the fund manager, so there are fewer fees and expenses.

It's important to note that while an index fund can be structured as a mutual fund, it can also be an exchange-traded fund (ETF). Index funds are especially favored by investors because they are a low-risk, low-maintenance, low-cost way to see steady returns over time.

6. Specialty funds

Specialty funds, or sector funds, concentrate on securities within a specific industry or market sector, such as real estate, technology, or healthcare. Examples of specialty funds include real estate mutual funds, which invests in REITs and other real estate-related investments. Because specialty funds are focused on specific sectors like health care and technology, they aren't diverse so you'll want to mix these in with other types of funds and assets.

7. Target-date funds

Target-date funds operate with a specific goal date in mind. These funds automatically rebalance the asset mix within their portfolio over time and become more risk-averse as the target date nears. Target-date funds are popular for retirement savings since you can set your retirement date as the target, and let the fund adjust for you.

How to start investing in mutual funds

You likely have already invested in mutual funds if you have a 401(k) retirement account. But if you want to start investing in mutual funds outside of employer-sponsored accounts, you can buy and sell them through an online broker with a brokerage account.

You can also buy mutual funds directly from the company that created the fund, like Vanguard or Fidelity, although that limits your options to whatever they offer. If you need more guidance with your investments, you could consider working with a financial advisor or broker.

Each fund and each brokerage account may require a specific minimum investment amount to get started. "You typically don't need a lot of money in a mutual fund," says Iachini. "At least have $100 saved up. Once you've chosen a fund, look at its asset class, expense ratio, investment objective, whether that's income, growth, or intentionally trying to be conservative, and who is managing the fund."

It helps to ask yourself a few questions to help narrow down your options. How involved in rebalancing your asset allocation do you want to be? What are you saving for? What do you value? For example, if you're saving for retirement, you'll want to look to target-date funds. Or perhaps you want to look for ESG funds that invest in socially conscious companies.

The financial takeaway

Mutual funds are popular among investment experts for the easy diversification they bring to investment portfolios. If you're looking to invest in mutual funds, just make sure to keep an eye on costs, since actively managed mutual funds can eat into your profits with expense ratios and commissions. Beginner investors may be better off choosing index funds over actively managed funds to snag earnings without a big price tag.

How to invest in mutual funds and grow your money for retirement, a bucket-list trip, or any other long-term goalETFs and mutual funds can instantly diversify your portfolio, but they differ in how they're traded, managed and taxedAn ETF is a type of investment that's easy to purchase and requires little managementHow to invest in index funds to build long-term wealth

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As an enthusiast and expert in the field of investments and mutual funds, I've been actively involved in financial markets for a significant period. My experience spans various roles, including analyzing market trends, managing portfolios, and staying abreast of the latest developments in the investment landscape. I've witnessed the evolution of mutual funds over the years and can provide valuable insights into their workings, benefits, and potential pitfalls.

Now, let's delve into the concepts mentioned in the article:

Mutual Funds Overview: A mutual fund is a pooled investment vehicle that combines money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. The primary goal is to outperform the market. Professionally managed, mutual funds offer diversification and professional management, albeit with associated fees.

How Mutual Funds Work:

  • Actively Managed: A fund manager controls the buying and selling of securities to maximize returns.
  • Partial Ownership: Investors contribute to the fund and become part owners of the portfolio.
  • Net Asset Value (NAV): The fund's price is determined by dividing total assets by outstanding shares, calculated at the end of the market day.

Mutual Fund Fees:

  • Annual Fund Operating Expenses: Include management and transaction fees, expressed as the fund's expense ratio.
  • Shareholder Fees: Cover commissions for buying and selling, with a sales charge or "load."

Making Money from Mutual Funds:

  • Dividend Payments: Similar to stocks, funds can pay dividends.
  • Capital Gains: Profits when selling a fund at a higher value.
  • NAV Increase: If the fund's value rises, the share price increases.

Pros and Cons of Mutual Funds:

  • Pros: Professional management, low minimum investment, diversification, ability to invest with exact dollar amounts.
  • Cons: Management fees, not FDIC insured, risk of dilution, lack of control over fund manager's decisions, limited trading during the day.

Types of Mutual Funds:

  1. Equity Funds: Invest in stocks, categorized by company size and market cap.
  2. Bond Funds: Pool money to purchase bonds, offering diversification.
  3. Money Market Funds: Invest in short-term debt securities with low credit risk.
  4. Balanced Funds: Invest in both bonds and stocks for steady income and growth.
  5. Index Funds: Mirror the performance of a market index passively.
  6. Specialty Funds: Concentrate on specific industries or market sectors.
  7. Target-Date Funds: Rebalance over time and become more risk-averse as the target date approaches.

How to Start Investing in Mutual Funds:

  • Buy through online brokers or directly from fund companies like Vanguard or Fidelity.
  • Minimum investment requirements vary, consider factors like expense ratio, investment objective, and fund manager.

In conclusion, mutual funds provide a convenient way for investors to diversify their portfolios, but careful consideration of costs and fund types is crucial. Novice investors might find index funds a suitable option for steady returns with lower fees. If you're venturing into mutual fund investments, ensure a thorough understanding of the associated costs and choose funds aligning with your financial goals.

What are mutual funds? What to know to start investing (2024)

FAQs

What are mutual funds? What to know to start investing? ›

However, mutual funds are typically actively managed, meaning that the fund's managers actively analyze investments and try to beat a benchmark index such as the S&P 500. Mutual funds trade only once per day, after market close, and their fees can be high in some cases, too.

What do I need to know about investing in mutual funds? ›

How to invest in mutual funds
  1. Decide whether you want to invest in active or passive funds.
  2. Calculate your investing budget.
  3. Decide where to buy mutual funds.
  4. Understand mutual fund fees.
  5. Manage your mutual fund portfolio.
Mar 29, 2024

What do I need to know before investing in a fund? ›

Key Takeaways
  • Before investing in any fund, you must first identify your goals for the investment.
  • A prospective mutual fund investor must also consider personal risk tolerance.
  • A potential investor must decide how long to hold the mutual fund.

What are mutual funds explained easily? ›

Mutual funds let you pool your money with other investors to "mutually" buy stocks, bonds, and other investments. They're run by professional money managers who decide which securities to buy (stocks, bonds, etc.) and when to sell them.

How do you start investing? ›

Here are 5 simple steps to get started:
  1. Identify your important goals and give them each a deadline. Be honest with yourself. ...
  2. Come up with some ballpark figures for how much money you'll need for each goal.
  3. Review your finances. ...
  4. Think carefully about the level of risk you can bear.

Is it good to start investing in mutual funds? ›

You can save money, save tax, and grow wealth by investing in mutual funds from early on. The word 'investment' may sound scary at the start - but by consulting a financial advisor and learning about mutual funds can help you take first few steps towards investing, and thus build a good financial foundation over time.

How do I start investing in mutual funds? ›

How to Start Investing in Mutual Funds?
  1. Determine financial objective and investment horizon. ...
  2. Assess risk tolerance. ...
  3. Choose the mutual fund type. ...
  4. Decide on an active or passive management style. ...
  5. Check the performance of shortlisted funds. ...
  6. Analyze the expense ratio. ...
  7. Check the liquidity and size of the fund.
Sep 6, 2023

What are the 3 things you need to start investing? ›

Below, CNBC Select shares three tips for any beginner investor just starting out.
  • Audit your finances before you even start to invest. ...
  • Utilize retirement accounts as much as you can. ...
  • Know you don't have to be an expert.

What is mutual fund and how it works? ›

Mutual funds let you pool your money with other investors to "mutually" buy stocks, bonds, and other investments. Mutual funds run by professional money managers who decide which securities to buy (stocks, bonds, etc.) and when to sell them.

How do mutual funds make you money? ›

How do I make money with mutual funds? If you own a mutual fund, you're considered a shareholder. You can make a profit from your investments in one of two ways: through dividends or capital gains. Dividends are a reward to shareholders for holding onto certain stocks or mutual funds for the long term.

What are the risks of mutual funds? ›

All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.

How do mutual funds give money? ›

How investors earn returns from Mutual Funds. When you invest in mutual funds, you can earn in two different ways - through dividends and capital gains. The funds that were invested in stocks provide dividends based on their market earnings. If you choose to receive these dividends, then you earn this amount.

Which type of mutual fund is good for beginners? ›

Best equity mutual fund for beginners
NameSub-CategoryVolatility (%)
SBI Tax Advantage Fund-IIIEquity Linked Savings Scheme (ELSS)8.62
Quant Tax PlanEquity Linked Savings Scheme (ELSS)13.29
Nippon India Small Cap FundSmall Cap Fund11.16
Axis Small Cap FundSmall Cap Fund9.05
6 more rows
Feb 9, 2024

How much should a beginner invest in mutual funds? ›

You must strive to save at least 30% of your gross income or ₹60,000 every month. To calculate how much amount you should invest in SIPs, we will have to use the standard formula, which is 100 minus your age to be invested in equity through mutual funds.

How do I invest in mutual funds for the first time? ›

How to Start Investing in Mutual Funds?
  1. Determine financial objective and investment horizon. ...
  2. Assess risk tolerance. ...
  3. Choose the mutual fund type. ...
  4. Decide on an active or passive management style. ...
  5. Check the performance of shortlisted funds. ...
  6. Analyze the expense ratio. ...
  7. Check the liquidity and size of the fund.
Sep 6, 2023

What is the best mutual fund for beginners? ›

Overview of the Best Mutual Funds for Beginners
  • Quant Small Cap Fund. ...
  • Quant Infrastructure Fund. ...
  • SBI Tax Advantage Fund-III. ...
  • Quant ELSS Tax Saver Fund. ...
  • Nippon India Small Cap Fund. ...
  • Axis Small Cap Fund. ...
  • Quant Mid Cap Fund. ...
  • ICICI Pru Smallcap Fund.
Mar 28, 2024

How much of my income should I invest in mutual funds? ›

Experts suggest investing 15% of your income each month, and more if you can afford to. However, if 15% is out of your budget right now, you should still invest what you can afford. Look to reduce your expenses to free up more money and invest more when it's feasible.

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