Mutual funds allow you to create a well-diversified portfolio without the burden of choosing individual stocks and bonds. Whether you’re investing in a retirement account or a taxable brokerage account, mutual funds might be the right tool to help you grow wealth.
But as with any investment, it’s important to do your research and understand just what you’re getting yourself into. Keep reading to learn how mutual funds work, how to add them to your investment portfolio, and a few potential downsides to be aware of.
What Is a Mutual Fund?
A mutual fund is a type of pooled investment that allows investors to gain exposure to many different assets through a single investment. The fund pools money from its investors and uses it to buy stocks, bonds, and other securities. Each investor benefits from their small percentage of each underlying asset without owning them directly. It’s an efficient way to build wealth and plan for financial independence.
How Do Mutual Funds Make You Money?
There are three ways you can make money with mutual funds. The first is through dividends, which are regular cash payouts from the underlying stocks and bonds. In fact, some mutual funds are designed to provide a regular source of income for investors.
The second is capital gains, which means selling a fund that has increased in price. At the end of the year, these funds distribute the capital gains to its investors. “You earn money the same way you’d earn money investing in most other ways,” says Erin Lowry, the author of Broke Millennial Takes on Investing. “If the value of your investments has increased by the time you sell, then you’ve made money.”
The third way is through net asset value. Mutual funds trade at the end of trading day and this is when their assets are valued. These assets are known as NAV, or net asset value. It’s the price per mutual fund share. As these funds increase, the price to purchase shares does too. There are no immediate distributions but you’d make money should you decide to sell it.
“Mutual funds are often products that are purchased for a longer time-horizon (fancy investing jargon for time until you need the money and therefore sell your investment) instead of a quick buy and sell as soon as the price of the fund has increased,” Lowry said.
Can you lose money in a mutual fund?
While it’s definitely possible to grow wealth in a mutual fund, it’s also possible to lose money. Stock mutual funds, in particular, are closely tied to the performance of the stock market.
As an example, look at the Vanguard 500 Index Fund (VFIAX), which tracks the performance of the S&P 500. In 2018, the fund actually had a negative return of -4.38%. And during the recession in 2008, it had a negative return of -37%. But over long periods of time, the index has gone steadily up. There hasn’t been a single 20-year period in its history in which the S&P 500 posted negative returns, according to data compiled by Measure of a Plan.
The name of the game when investing in mutual funds is long-term. Investors don’t want to worry about downturns in the market, because the goal is for mutual funds to make money for future goals such as retirement.
“All investments are a risk no matter the type,” Lowry said. “That holds true for real estate, art, stocks, angel investing — you name it. So yes, mutual funds can lose money. It’s important to remember though that you haven’t actually ‘locked in your losses’ until you sell.”
What Are Different Types of Mutual Funds?
Mutual funds generally fall into four categories depending on the type of asset they invest in.
First, equity funds invest in the stocks of publicly traded companies. These funds might track the performance of a particular stock index like the S&P 500 or the Dow Jones Industrial Average. They could also invest in a particular sector or type of stock, such as healthcare industry mutual funds or growth mutual funds.
Another type of mutual fund is a bond fund, which invests in bonds and other debt securities. Bond funds can hold both corporate and government bonds, though they often specialize in one or the other.
Next, money market mutual funds invest in short-term debt securities that are of generally high quality. In fact, these funds are legally required to only invest in these high-quality investments, and so they tend to be lower-risk investments.
Finally, a target date fund or lifecycle fund can hold a variety of different securities, including stocks, bonds, and more. These funds often identify a particular retirement year. For example, a target date fund for investors who plan to retire in 2060 would start with a more aggressive investment approach, but reduce the fund’s risk as the predetermined retirement date nears.
Active vs. Passive Mutual Funds
Mutual funds are either actively or passively managed. A passive fund, more commonly known as an index fund, tracks the performance of a particular market index. For example, you could invest in an index fund that tracks the performance of the S&P 500.
In the case of actively managed funds, there’s a fund manager who regularly buys and sells assets within the fund. With these funds, the goal isn’t simply to match the performance of the market. Instead, they’re trying to beat the market.
“A managed fund is predicated on the notion that there can be investment management acumen that you can pay for that will deliver better results,” said Jill Schlesinger, CFP and the host of the Jill on Money podcast. “Study after study shows it’s very difficult to beat the performance of an index, partially because those managed funds cost money. You may be able to beat the index, but then you factor in the cost of the management and the numbers don’t look so hot.”
Experts say passive funds are the way to go.
How to Get Started Investing in Mutual Funds
For most investors, their first exposure to mutual funds is through a retirement account like a 401(k) or an individual retirement account (IRA). Many employer-sponsored retirement plans offer these investments because of the simplicity and diversification they provide.
But you can also invest in mutual funds through a taxable brokerage account. No matter what type of account you use to invest, the process is as quick as logging into your account and selecting your investments.
When it comes to investing, the most important step is getting started. Mutual funds offer a well-diversified portfolio to help you build a complete portfolio in just a few investments.
But it’s important that you do a bit of research upfront. Pay attention to the objectives of the fund to ensure it fits with your investment goals. Additionally, be sure to look at what fees the fund charges. The higher the fees, the less of your returns ultimately remain in your portfolio. You want funds that have low expense ratios. Typically a low expense ratio falls somewhere near .2%. Expense ratios with 1% are on the higher side and experts agree those are the ones you should stay away from.
“The lowest barrier to entry is to just choose either a target date fund which targets the date in the future you’ll start to need some of your money,” Schlesinger said. “If you took a stock index fund and a bond index fund and an international index fund and those were your three baby steps, that would be a nice place to start.”
But according to Schlesinger, the most important thing is simply to get started. While it’s important to choose a fund that fits with your goals and risk tolerance, don’t let fear of the unknown prevent you from investing early and often. Do your research and start investing as soon as you can.
“As much time as people spend on investments, I wish we spent more time talking about the habit of getting into the habit of saving,” Schlesinger said. “The most important thing investors can do is just get into the habit of saving and investing consistently over time.”
Mutual Fund Pros and Cons
Mutual fund investing comes with some major advantages. First, because of the number of assets they invest in, mutual funds make it easy to create a well-diversified portfolio with just a few holdings. And because a professional manages the fund on investors’ behalf, you don’t have to worry about choosing your own investments.
Another advantage of mutual funds is that they often have low fees, especially in the case of index mutual funds. It’s not uncommon to find index passively-managed funds with expense ratios below 0.05%.
That being said, there are also some downsides to mutual fund investing. First, while index fees tend to have low fees, actively managed funds can have higher fees. The reason for these higher fees is that there’s a fund manager taking a hands-on role in building the fund.
“An actively managed fund will cost more than a passively managed fund,” Lowry said. “That’s not necessarily a reason not to purchase an actively managed fund, but a consideration.”
For some investors, mutual funds may also lack the control they prefer. Mutual funds also trade at the end of the day. For investors who want more control over when a trade happens and the price they pay, exchange-traded funds (ETFs) might be a better fit.
Mutual Fund FAQs
How much can you earn in a mutual fund?
There are literally thousands of mutual funds on the market, and the average return is different for each fund. That being said, a total stock market index mutual fund could expect to see average annual returns of about 10%.
Can you lose money in mutual funds?
It is possible to lose money in a mutual fund if the value of your shares decreases after you purchase them and you sell the investment before recovering your losses.
How much does it cost to invest in mutual funds?
The cost to invest in a mutual fund depends on the particular fund you choose. While actively managed funds have expense ratios that near or exceed 1.0%, passively managed funds can have fees below 0.05%. Some total market index funds carry no fees at all.
Are mutual funds a safe investment?
Any time you invest, you risk losing your money. That being said, because mutual funds are diversified and give you exposure to many assets at once, they’re generally considered safer than investing in individual stocks.