A mutual fund is a type of investment that takes money from you and other investors and invests it in a basket of stocks, bonds, and other securities known as a "portfolio."
When you invest in a mutual fund, you get an ownership stake in the fund and the money it makes. These investments are popular with beginner investors, because they are often professionally managed, have a relatively low minimum investment, offer a diversified range of underlying securities, and can easily be converted to cash.
Mutual fund investing is a goal-oriented planning process. It's important to establish your objectives and investing style before you start investing in mutual funds, so that you can allocate your dollars more efficiently.
Key Takeaways
- Your money is invested in a group of stocks, bonds, and securities when you invest in a mutual fund.
- You own a piece of the fund, and you’re entitled to a share of any income that it generates.
- Stock funds, bond funds, and money market funds are the most common types of mutual funds, with money markets providing the least risk.
- The mutual funds that are likely to produce superior returns often come with increased risk.
Determining Your Mutual Fund Investing Strategy
Before you start investing in mutual funds, establish a framework for how you want to invest that takes into account the following:
- Financial objective: Set a goal for investing, such as capital appreciation (growth in the value of the asset) or a stable income in retirement. Having a goal in mind for your investments will aid you in making related investment decisions such as the mutual fund types to choose, tax considerations, and how much money you will need to get started.
- Time horizon: This is the number of months or years over which you plan to invest to achieve your financial objective. For example, your time horizon might be one, five, or ten years, and each might warrant different mutual funds.
- Risk tolerance: Risk refers to the potential for financial loss that a mutual fund carries and is a function of the underlying securities held by a fund. In general, mutual fund types with a greater potential for returns (namely stock funds) also come with greater risk. Funds that generate lower returns (money market funds, for example) carry less risk. It's important to choose mutual funds that only expose you to a level risk that you are willing to handle.
Finding the Right Type of Mutual Fund for You
There are many different types of funds, but all you need to know to begin investing in mutual funds are the three basic types:
- Stock funds: As the name suggests, these funds invest mainly in stocks, or "equities." They typically generate greater returns than the other two types of funds but also carry the highest level of market risk, since stock prices can rise or fall dramatically with changes in the economy or demand. You might be willing to tolerate the risk if you seek aggressive capital appreciation and have a longer time horizon (ten years or more), since you'll have more time to make up for potential declines in the value of your holdings.
- Bond funds: Bonds and other debt instruments are the underlying securities of these mutual funds. They are generally riskier than money market funds, which makes them more appropriate when investing over an intermediate term of five to ten years. The level of risk varies by the type of bonds they invest in. Those that are invested in companies with poor credit ratings or in long-term bonds are riskier than those invested in insured bonds or short-term bonds.
- Money market funds: These low-risk bonds invest in quality short-term assets, such as cash and government securities, and are suitable if your time horizon is less than three years. They traditionally offer a steady income at lower rates of return than stock or bond funds, which might be acceptable if you have a shorter time horizon.
Note
If you are seeking capital appreciation and income at a lower level of risk than stock funds provide, consider balanced funds, which invest in some combination of the three basic types.
Mutual Fund Taxation
One crucial factor to consider when you start to invest in mutual funds is how the proceeds from shares of mutual funds will get taxed when you eventually sell them. The taxation of mutual fund proceeds depends on the type of account you use for investing. Some accounts, such as Individual Retirement Accounts (IRAs), confer tax advantages over standard brokerage accounts.
Tax-Advantaged Accounts
Commonly, investors who are saving for retirement choose to invest in mutual funds through a traditional IRA, Roth IRA, or 401(k). All three account types provide tax-deferred growth of contributions and earnings, but they offer additional tax perks at different times.
You pay into a traditional IRA or 401(k) with pre-tax dollars, which means that you can deduct your contributions to these accounts from your taxable income. You will pay taxes on the contributions or earnings (growth of contributions) at the time of withdrawal.
In contrast, you fund a Roth IRA with post-tax dollars. As a result, you can't deduct the contributions from your taxable income, but withdrawals of contributions and earnings are tax-free if certain requirements are met.
Taxable Brokerage Accounts
These are non-retirement accounts through which you can invest in mutual funds. They are also called "regular brokerage accounts" or "individual brokerage accounts."
If you sell mutual fund shares for more than the purchase price, the difference is known as a "capital gain." You will pay capital gains tax on the gain upon the sale of the investment. However, if you sell a mutual fund after holding it for more than one year, it's considered a long-term capital gain, which is taxed at lower rates than short-term capital gains on investments you hold for one year or less. In addition, you will pay ordinary income tax on any dividends you may receive.
Buying Mutual Funds
When you are ready to start investing mutual funds, open the account of your choice and then purchase shares of a mutual fund through an investment company or a licensed full-service or discount brokerage firm. The purchase price of a mutual fund will amount to the fund's per-share net asset value plus purchase fees like sales loads.
Many mutual funds in non-retirement accounts require a minimum initial investment amount, which might be $3,000 or more. However, some investment firms offer funds with lower minimums. For example, Fidelity requires no minimum investment for certain funds, and Vanguard allows an investment of $1,000 on certain funds.
Note
When investing with mutual funds in a 401(k), there isn't a minimum investment amount; all that is required to get started is to complete the employer's paperwork.
Automatic Investing
If you commit to an automatic investment plan, where a set amount is periodically invested into a fund on autopilot, you may be able to get started investing in mutual funds with a lower initial investment. BlackRock's mutual fund minimum investment amount of $1,000 drops to $50 if you enroll in automatic investing, for example.
This is a great option if you're a student or want to start investing, but debt repayment or other financial obligations would prevent you from meeting the standard minimum investment amount.
