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Mutual Funds: Understanding The Basics

Dan Rafter8-minute read
September 21, 2020

A mutual fund is an investment strategy that lets you pool money with other shareholders to purchase stocks or bonds, often as a tool for building retirement savings. Mutual funds make it easier for individuals to access a wide array of stocks and bonds.

What Are Mutual Funds?

One of the benefits of mutual funds is that they are overseen by professional managers. These managers review mutual fund portfolios on an ongoing basis and make changes according to their performances. This makes mutual funds a good choice for investors who don't want to spend a significant amount of time researching stocks, bonds or other investment opportunities.

When investing in a mutual fund, you can also specify how much risk you want to take on. You can then invest in mutual funds that meet that risk.

If you’re just getting started with investing and you have decades before you plan to retire, you might choose to invest in a mutual fund that is made up of stocks that are more volatile and come with more risk. These stocks can generate a higher potential return. But because of their volatility, they can also lose value more quickly. As you get closer to your retirement date, you might switch your investments to a lower-risk fund that’s less likely to result in either big returns or big losses.

How Do Mutual Funds Work?

Mutual funds work because they combine the money you’re investing with the dollars of other investors. This money is then invested in a portfolio made up of a variety of stocks and bonds. The goal is to allow individuals to invest their money in portfolios that they otherwise wouldn't be able to afford if they were forced to invest on their own.

Mutual funds also allow you to invest in a wider variety of stocks and bonds than you might be able to on your own. You might choose to invest in a mutual fund that focuses on stocks from companies based overseas or those that focus on individual businesses such as companies in biotechnology or those in emerging industries.

Different companies offer their own mutual funds, and you can invest with any of them. Some of the bigger mutual fund companies include Fidelity Investments, Vanguard and Oppenheimer. These companies offer mutual funds that are overseen by professional managers.

How do you earn money from a mutual fund?

  • Dividend payments: There are thousands of mutual funds in which you can invest. But only one type of fund pays out dividends to investors on a regular basis. Those are known as dividend mutual funds, and they only include high-dividend stocks and high-coupon bonds. The companies represented in these mutual funds pass a portion of their profits to their shareholders – including those who have invested in them through mutual funds – in the form of regular dividends.
  • Capital gains: If you own a stock fund, you'll also make money when the stocks in your mutual fund increase in value. This is known as capital gains.
  • Interest income: If your fund is instead focused on bonds, you'll often make money through interest income.
  • Selling your shares: You can also earn a profit by selling your shares in a mutual fund, if these shares have increased in value since you purchased them. Be aware, though, that you might have to pay fees or commissions when you sell. Selling your shares might also trigger a tax hit.

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How Can I Buy A Mutual Fund?

The easiest way to invest in a mutual fund is through your company's 401(k) or 403(b) plan, if it offers one. In these retirement plans, you automatically deposit a certain percentage of each paycheck into a mutual fund offered by a company that has contracted with your employer. You'll have the choice of investing in a variety of mutual funds, including those focusing on high-growth, high-risk stocks and bonds and those taking a more conservative investment approach.

If your company doesn't offer its own retirement savings plan, you can invest in a mutual fund directly through the financial companies that offer them, companies such as Fidelity, Vanguard and T. Rowe Price. Again, you'll have the opportunity to choose from a range of mutual funds, whether they are focused on one particular sector, on investments in foreign countries or on investments deemed high-risk and high-growth.

Finally, you can take what is known as the "fund supermarket" approach. This is when you work with mutual fund providers -- again, companies such as Fidelity and Vanguard -- to set up a brokerage account that allows you to buy mutual funds from a variety of providers.

The key, though, is to work with a financial advisor who can help you determine the best investment choice. There are a lot of mutual fund options out there and choosing among them can be overwhelming. That’s why it’s so important to seek the advice of a financial professional.

Types Of Mutual Funds

There are three main types of mutual funds in which you can invest.

Equity Funds

Equity funds are primarily made up of stocks. These funds can be actively managed by a manager or management team that tries to beat the overall performance of the stock market. They can also be passively managed. Known as index funds, passively managed mutual funds are set up to mimic the performance of a specific financial index, such as the Standard & Poor’s 500 Index.

There are several types of equity funds. These include:

  • Funds based on company size: These funds might focus on small-cap, mid-cap or large-cap funds. As those names suggest, these are companies of different sizes. Small-cap companies are smaller than large-cap companies, while mid-cap companies are in the middle.
  • Industry funds: These equity funds are focused on the stock of companies in specific industries. Your industry fund might focus on companies in the oil business or those in the technology field, for example.
  • Growth funds: These equity funds are focused on companies that are in growth mode. Growth funds could bring higher returns, though they also come with more risks.
  • International funds: In an international equity fund, you’ll invest in businesses that are owned by foreign entities or are located overseas.

Fixed-Income Funds

As the name suggests, fixed-income funds are made up of fixed-income securities such as U.S. Treasury bonds, corporate bonds and municipal bonds. Because of this, these are often referred to as bond funds. Fixed-income funds pay investors set interest payments until they reach maturity, so they are also a good way for investors to earn a steady stream of income.

There are two main types of fixed-income funds:

  • Bond funds: These funds invest in government and corporate debt, in the form of bonds. These funds are less volatile than stock-based funds and are less likely to result in big losses. However, they also have less potential for growth than do equity mutual funds.
  • Money market funds: Money market mutual funds are similar to bond funds, only these funds invest in shorter-term government and corporate debt such as U.S. Treasury bills. These are considered the safest of mutual fund investments but also bring lower returns than bond funds or equity funds.

Balanced Funds

If you're looking for more variety in your mutual fund, a balanced fund might be a good choice. These funds contain a mix of stocks and bonds. Some balance funds also contain money market investments. These bonds typically have a fixed ratio of investments. A fund, for instance, might contain 60% stocks and 40% bonds.

Types of balanced funds include:

  • Asset allocation fund: This fund type focuses on diversity, containing a mix of assets such as stocks, bonds and cash equivalents, which include such securities such as U.S. government Treasury bills, certificates of deposit and other money market vehicles. These funds are popular because they come with less risk. If your investments are spread out over a wider range of savings vehicles, you’re less likely to take a big hit if one industry suffers through financial struggles.
  • Target-date fund: A target-date fund is designed to minimize risk as you get closer to retirement age. The mix of investments in these funds becomes more conservative the closer you get to a target date, which is usually the date of your retirement. A target-date fund might start out weighted heavily toward stocks but then shift toward a balance favoring bonds as you get nearer your retirement date.

Fees Associated With Mutual Funds

Investing in a mutual fund isn't free. You'll have to pay a fee, which makes sense: It costs money to run a mutual fund, and the companies providing them are in business to make a profit.

There are two main types of fees associated with mutual funds.

Your fund's operating expenses are fees that the provider of your fund charges to cover the costs of managers, accountants, lawyers and others involved in the daily management of the mutual fund. These fees usually run from 0.25% – 1.5% of the amount of money you deposit in your fund for the year.

You might also face several shareholder fees, one-time costs that you incur when you buy or sell shares in a mutual fund.

These could include a redemption fee, a charge if you sell your mutual fund shares within a short period of time of buying them, and an exchange fee, which might be levied against you if you transfer shares of your mutual fund to another fund operated by the same investment company.

Sales loads are a common fee, too. These are the commissions you pay whenever you buy or sell mutual fund shares.

Should I Invest In A Mutual Fund?

There are many benefits to investing in a mutual fund. There are also some negatives to consider.

On the plus side:

Depending on your mutual fund type, your portfolio might be overseen by a professional fund manager. This manager can analyze market trends and research companies before making important investment decisions on your behalf.

Mutual funds come with built-in diversification. This is important: You want your investment dollars to be spread across a range of stocks and bonds. This way, if a specific industry or investment type struggles and loses value, another of your investments might be performing at an above-average level, providing you with financial protection.

Mutual funds are also liquid investments. It’s easy to buy and sell these investments quickly, which could be important if you need quick access to cash.

On the negative side:

Investing in a mutual fund will cost you fees and charges. You’ll have to do your research to find the fund that’s a good fit for you and doesn’t charge fees that are too expensive.

Even though you purchase shares when you invest in a mutual fund, you don’t get the same voting rights as other shareholders.

Returns can also fluctuate when you invest in a mutual fund. There are no guarantees that your investment will rise in value.

Mutual Funds Vs. ETFs

Mutual funds aren't your only option for your investment dollars. You can also invest in exchange-traded funds, better known as ETFs. These funds have several similarities with mutual funds, including:

  • Both ETFs and mutual funds are made up of a wide mix of assets.
  • Because of this, they help investors diversify their portfolios.

There are also several differences between ETFs and mutual funds:

  • Investors purchase mutual funds directly from investment companies, while ETFs are traded between investors on the stock exchange.
  • ETFs are traded throughout the day. Mutual funds, though, trade just once a day after the stock market closes.
  • Mutual funds are professionally managed. ETFs are not and are tied to a specific market index.
  • Mutual funds come with fees that you won't pay when investing in ETFs.

Final Thoughts On Mutual Funds

Mutual funds offer people an easy way to invest in a wide mix of stocks, bonds and other vehicles, especially those who can invest in them through an employer-sponsored retirement plan. Mutual funds aren’t perfect – they do come with fees, returns aren’t guaranteed and it can be challenging to pick the right one among the wide variety of funds available – but they have opened up stocks and bonds to more people.

It’s getting easier to invest in mutual funds today, especially if you consider an index fund, a type of mutual fund that is growing in popularity.

Learn To Invest

There's no money tree, but that doesn't mean you can't watch your money grow!

Dan Rafter

Dan Rafter has been writing about personal finance for more than 15 years. He's written for publications ranging from the Chicago Tribune and Washington Post to Wise Bread, and