When it comes to your finances, the old saying rings true: Don’t put all your eggs in one basket. The vast majority of financial planners advise investing in many different types of stocks, bonds, and other assets, not just a couple that sound interesting.
But especially when you’re starting out, you probably don’t have enough money to spread it across all different types of investments. That doesn’t have to stop you—in fact, that’s exactly where mutual funds come in.
In this guide, we’ll cover everything you need to know about mutual funds: What they are, how they work, and whether they’re right for you.
What Are Mutual Funds?
Mutual funds were designed for people to get started investing with small amounts of money. You can think of them as suitcases filled with different types of securities, such as stocks and bonds. Buying even one share of the fund immediately invests you in all the individual securities the fund holds.
The benefit? Instant diversification. Say you invest in a mutual fund that holds stocks of every company in the S&P 500. If one company in the S&P 500 goes bankrupt, your fund might lose some value, but you most likely won’t lose everything. But if your whole investment was in that one company’s stock, you’d lose all or most of your money.
What Types of Mutual Funds Are There?
Mutual funds can invest in stocks, bonds, real estate, commodities, and more. There are over 20,000 mutual funds that cover every investing strategy you can imagine. Some common strategies include:
Asset Class Funds: Asset classes are groups of similar assets that share similar risks, such as stocks, bonds, cash, or real estate. Some funds specialize in a particular type of investment or asset class—for example, large cap growth stocks or high yield bonds. These mutual funds assume that you or your adviser will choose the strategic mix of funds that’s right for you.
Sector or Industry Funds: Some funds will attempt to represent all or most of the stocks in a particular sector or industry. What’s the difference? Sectors are broader than industries—for example, oil is an industry, but energy is a sector that also includes coal, gas, wind, and solar companies. The stocks in each industry or sector share similar characteristics and risks.
Target Date Funds: A target date fund will provide you with a mix of asset classes (for example, 20% bonds and 80% stocks). They assume you will terminate the fund at some year in the future, usually when you retire, and they shift to less risky investments as the target year approaches. Target-date funds are intended to be a generic, low-cost solution to retirement saving and. They can be a good choice for a 401(k) investment if you don’t have the time or expertise to pick funds.
Speaking of picking funds…
How Are Mutual Funds Managed?
Mutual funds can be managed actively or passively. Passively managed funds attempt to track an index, such as the Russell 2000 (an index of 2,000 small-cap U.S. companies). In other words, if one company leaves the index and another one joins, the fund sells and buys those company’s stocks accordingly. The risk and return of these funds is very similar to the index.
Actively managed mutual funds attempt to beat the performance of an index. The idea is that with careful investment selection, they will get higher returns than the index. Empirical evidence shows that they can’t, at least for more than a short period of time1. Data2 shows that investors are unlikely to beat the market over time. You are more likely to succeed with a portfolio of passive funds that track indices.
What Are the Costs of Investing in Mutual Funds?
All mutual funds have some expenses, but they can vary a lot from one fund to another. It’s important to understand them, because fund expenses can have a big impact on your returns over time.
Another problem with actively managed funds is that they typically cost you more. Why? These funds are paying people who make investment decisions, and they are making more trades, which have transaction costs. You won’t get a bill, but your returns on the fund will be reduced by the fund’s expenses. Some brokerage firms also charge commission for buying mutual funds.
A good alternative to actively managed funds are index ETFs, which brings us to:
What Are Exchange Traded Funds (ETFs)?
Mutual funds have been around since the 18th century, but the industry is constantly innovating. The latest idea is Exchange Traded Funds (ETFs).
Traditional (old-school) mutual funds are issued by the fund sponsor when you buy them and redeemed when you sell them. They are priced once a day, after the market closes, at the value of all the underlying securities in the fund divided by the number of fund shares—their net asset value (NAV). The investment choices in most 401(k) plans are these kind of funds.
Exchange Traded Funds (ETFs) trade on stock exchanges throughout the day. You buy them from and sell them to another investor—just like a stock. Since the assets in the fund are constantly changing value throughout the day, and the fund price is set by market supply and demand, it might trade a little higher or lower than its NAV at different points in the day, but ETFs generally track their NAV very closely. Both traditional funds and ETFs can be actively or passively managed.
ETFs have two advantages—liquidity and cost. Even though you pay a commission for buying or selling them—just like a stock, they generally have lower expenses that more than make up for it. Since they can be bought or sold whenever the market is open, you don’t have to wait until the end of the day to buy or sell. This liquidity can be a big advantage on days when the market is way up or way down.
Why Should I Invest in Mutual Funds?
Most investors need growth to reach their goals. Stocks offer the potential for growth, but they can be risky. A lot can go wrong with a company over time. Mutual funds are a better choice because they use diversification to reduce that risk significantly.
For most small investors, index funds make the most sense. With index funds you are not betting on a fund manager to “beat the market”—you own the market! Plus, the expenses of index funds are generally lower than actively managed funds.
What Funds Should I Buy in My 401(k)?
Most 401(k)s and other employer retirement plans don’t offer ETFs and still use traditional mutual funds. No problem—there are plenty of good traditional index funds. You’ll want to split the funds between U.S. stocks (both large and small), international, and emerging markets stocks, investment grade bonds, and high yield bonds. There are index funds for each of these asset classes.
Unless you or your advisor have decided on a specific allocation of your assets between stock and bond funds, a target date fund is a good choice. It contains a mix of stock and bond funds tailored to your time to retirement. Plus, if you stay with your company, it will adjust that mix to be less risky as you get older.
Retirement Hack: Don’t want to pay an advisor? Find a target date fund with a date close to when you plan to retire and use their mix of stocks and bonds. You can also check if you are on track for retirement with this retirement calculator.
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1A scorecard published by Standard & Poor’s tracks the performance of mutual funds over time. In their most recent issue, less than 2% of funds stayed in the top performing group more than two years.
2Markowitz, Harry. “Portfolio selection*.” The Journal of Finance 7.1 (1952): 77-91.