If you want to invest your funds in stocks and bonds but don't have the time to do all the research necessary to pick individual stocks, mutual funds may be your answer.
What Are Mutual Funds?
A mutual fund takes money from investors and purchases a basket of stocks, bonds and other assets. The goal is to create a more diversified portfolio with less risk than the average investor could do by themselves. Each mutual fund has a professional manager that decides what to buy and sell and when.
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How Do Mutual Funds Work?
You have two choices when it comes to the types of mutual funds: actively or passively managed.
With actively managed funds, the managers research and make decisions about investing a fund's money. Their objective is to outperform a market index. This is their way of justifying the fees you pay them to manage your money.
Index funds are examples of passively managed funds. The goal of an index fund is to match the performance of a market index such as the S&P 500. Managers of index funds do not buy and sell securities. They merely purchase and hold the stock or bonds in the index they are mirroring.
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The Initial Investment
Some funds require an initial investment of several thousand dollars, like the Vanguard® 500 Index Fund with a minimum of $3,000, while other funds do not have any minimums, such as the Fidelity® 500 Index Fund. You can get started with just a few dollars and add to your account when you have funds available. Some funds will also allow you to use the dividends for reinvestment in more shares of the fund.
What About the Fees?
It pays to shop around when selecting a mutual fund because the management fees can vary widely. Even within the same types of mutual funds, fees can range from reasonable to expensive.
You want to select a fund that performs well but has low management and administrative fees. High fees reduce the amount of your investment and result in a lower return. Even a small difference in fees can add up to a huge difference in returns over time.
Actively managed funds have higher fees to pay for the manager and administrative staff. Passive funds have lower fees because they do not require the same attention as actively managed funds .
You can purchase mutual funds directly from the company themselves, such as Fidelity or Vanguard, or you can buy them through a broker.
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Selecting a Mutual Fund
There are several factors to consider when selecting a mutual fund.
- Don't focus on the short-term: Look more at the return over the long-term, like three to five years. Every fund will have good years and bad years, and even good and bad days.
- Focus on expenses: You want to have as much of your investment as possible working for you, not being reduced administrative fees.
- Look at the risk-adjusted return: Some funds have more price volatility than others. You can check a mutual fund rating agency, such as Morningstar, to compare the long-term returns and star ratings of several mutual funds adjusted for volatility.
- Analyze the returns with the current manager: Find who the fund's manager is and look at the returns during his tenure. A fund's performance can be negatively affected by a change in management. This is particularly true for management changes at a small fund, but not so much at the large funds.
- Consider the tax consequences: If you are putting your mutual funds in a tax-deferred account, such as an IRA or a 401(k), you'll need to consider the type of returns that the fund generates. Is the fund creating profits that will be taxed at capital-gains rates or producing dividends that could be taxed at ordinary income rates?
Where to Purchase a Mutual Fund
You can purchase mutual funds directly from the company themselves, such as Fidelity or Vanguard, or you can buy them through a broker. If buying through a broker, you'll have access to a broader range of all types of funds, large and small.