What Are Mutual Funds? – Diversify Your Portfolio
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When it comes to popular investment types, mutual funds are one that you hear a lot about because they are considered a great buy-and-hold investment. This means you just buy a diversified collection of stocks and sit back and let them earn money for you without making changes or doing any work, much like you do with your 401k.
This ease is most appealing, as well as the fact mutual funds are very low-risk.
Simply put, a mutual fund is an investment that you, along with many others, buy shares of as a group. The fund is set together and managed by a professional manager who is a Registered Investment Advisor (RIA).
Since a team of professionals is working behind the scenes to buy and sell at opportune times, the fees are slightly higher than comparable investments like ETFs and index funds. You'll pay not to have to do anything, but consider that a worthy investment too, because your time is too valuable. Mutual funds comprise hundreds of securities representing hundreds, even thousands, of companies. When the mutual fund makes money, the managers make money, so it’s in their best interests to keep up-to-date on all things related to the securities within the fund.
In this article
Five types of mutual funds to include as part of your investment strategy
There are five primary types of mutual funds: equity funds, bond funds, money market funds, target date funds, and balanced funds. Many mutual fund investors find it wise to include several of these types of mutual funds as part of their investment portfolios so that the total value isn’t held in just one fund.
Here’s a look at each of the five types of funds:
Equity funds
Equity funds are just what their name suggests: you hold a tiny bit of equity in a publicly traded company. Mutual fund managers put together a portfolio of individual securities from companies that fit the mutual fund’s goal. Also called stock funds, they are designed to create capital appreciation over the long term. Small-cap funds have growth potential but also see more volatility. Large-cap funds are more of a low-risk investment because the portfolio of stocks is from solid, reputable companies.
Bond funds
Bond funds, sometimes referred to as fixed-income funds, hold various bonds. These are a mix of government, municipal, corporate, and mortgage bonds that pay regular dividends. This money is split between fund holders, although the amount varies from month to month due to the bond turnover in the fund.
Money market funds
Money market funds are made up of short-term debt with high liquidity. Those that invest in tax-exempt municipal securities may offer tax advantages to investors. While you won’t get high returns from money market funds, they offer a low-cost, low-risk investment in a diversified portfolio.
Target date funds
Target date funds are a common component in retirement accounts. They help ensure that your portfolio is properly balanced over time. Often including a year within the fund’s name, they start with an aggressive mix of securities to get higher returns in the early years. As your retirement draws near and your risk tolerance to ride the stock market waves declines, the portfolio is shifted into a higher percentage of bonds to preserve the money you’ve accumulated.
Balanced funds
Balanced funds give you the best of both worlds— equity securities and bonds— in a single portfolio. Each fund will have its percentage, usually leaning more heavily towards one than the other. This may be a good fit for those who want just one type of mutual fund. It’s similar to a target date fund but without the shift from aggressive to low-risk over time.
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Why invest in mutual funds?
With so many ways to invest your money, why choose mutual funds? Here are a few key reasons why mutual funds are an attractive investment.
- Mutual funds offer a diverse portfolio in one fund. With one fund, you can access a broad range of individual stocks. From low-risk picks to emerging markets, you spread the risk across hundreds of funds, so you don’t need to worry if you have too much money in one stock or another.
- Your money is easily accessible when you need it. Unlike real estate and certificates of deposit (CD), mutual funds are relatively liquid. It does take a day or two for the transaction to be settled and the total value of the sale to arrive in your bank account. You cannot do a real estate transaction in a matter of days, and if you cash out your CD before it matures, you lose the accumulated interest.
- Mutual funds are easy to set up. Whether you want to invest in mutual funds through your IRA or a non-retirement account, opening an account won’t take more than half an hour. Once you’ve funded it, buying is easy, and you can initiate new purchases in just minutes.
- Mutual funds are professionally managed. Since mutual funds are managed by professionals who are paid to manage them and beat the benchmarks, you don’t have to worry about whether or not it’s a good time to sell your single stocks. You can choose one with a solid track record as long as you can understand how income funds work, their annual fees, and expense ratios. It may not be a home run, but it’s better than savings account interest rates.
Related: Mutual Fund Investment Strategies
How they compare
Mutual funds vs. ETFs
Exchange-traded funds (ETFs), like mutual funds, are numerous securities that create a diverse portfolio. The main differences come into play with the costs. Because ETFs are passively managed and mimic a specific market index like the S&P 500, they are cheaper than actively managed mutual funds. Investors can buy and sell shares throughout the day, capitalizing on swings in the market that mutual fund investors don’t have access to.
Mutual funds vs. single stocks
Mutual funds offer convenience, diversification, and professional management that you don’t get with selecting and buying single stocks. There is a learning curve to investing in stocks that you don’t need to make with mutual funds. Additionally, transaction fees can quickly eat up your profits if you make frequent trades. On the positive side, with stocks, you can control what asset classes and companies you do and don’t buy shares of, but in mutual funds, the managers control the asset allocation.
Costs of mutual funds
As mentioned before, because mutual funds are actively managed, they have higher costs. Some of the costs go to pay the management team, cover their office overhead, and market the fund to continue its growth. Most funds have a load, which is finance-speak for commission. Sometimes, when you buy them, these loads are charged a front-load fee. Other times, there’s a back-load, which means you pay the fee when you sell. Long-term investors should consider no-load funds, which are exactly as they sound. But there’s a contingency: you can’t sell for a certain time, sometimes up to five years.
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Pros and cons of mutual funds
Pros
- Mutual funds are a convenient way to get a diversified portfolio without a lot of time spent researching investment options.
- When investing in a range of mutual fund types, even one of each, you have access to most asset classes.
- You can buy and sell mutual fund shares anywhere you have an internet connection.
- Mutual funds are professionally managed by professionals who spend their work hours ensuring they have the best mix of securities to meet the fund’s goals.
Cons
- Mutual funds have complex fee structures that aren’t always clear. It may be hard to compare a fund’s expenses to similar investments like index funds.
- Share prices are calculated once per day so you can’t take advantage of a sudden, temporary dip in the market and buy low.
- You can’t control the capital gains on securities that are bought and sold within the investment. Unlike single stocks, you don’t have control over when, or how often, securities are sold.
FAQs
How do I buy mutual funds?
When you, the investor, want to buy mutual fund shares, you can make your purchase at any time. However, it is not processed until the end of the trading day. This is because the individual securities that are held within the mutual fund are continually fluctuating so the total value of the fund isn’t known until trading ends for the day. This end-of-the-day price is called the net asset value or NAV.
Where can I buy mutual funds?
Before you buy shares of a mutual fund, you need an account with a financial service provider who offers mutual funds. Your retirement plan through your employer is a natural first place to look. You can also consider investment firms such as Vanguard and Fidelity, as well as banks, and credit unions.
How much do mutual funds cost?
When you invest in a mutual fund you buy shares of it at a price that changes once a day. This is based on how the individual securities within the fund performed on the stock market that day. Mutual funds have various expense costs, which you can see in the funds prospectus, a document that gives specific details of the fund including the investment objectives, expense ratio, and risks.
Are mutual funds a good investment for everyone?
Every investor has different goals, but for most people, mutual funds are a solid addition to their overall investment portfolio. They are a great set-it-and-forget-it type investment that doesn’t need constant monitoring.
The bottom line
Mutual funds are a good investment for people who want to keep their money semi-liquid with the potential for excellent growth over the years.
Remember, the tortoise always wins the race. If you’re trying to pick between single stocks or mutual funds, opting for the latter exposes you to less risk. Once you pick a few great funds to invest in, you can set up automatic deposits so that you don’t have to think about your funds, but once or twice a year when, you get the updated prospectus or tax forms to report capital gains and dividend distributions.
And if you decide mutual funds aren’t your thing, that’s fine. Plenty of perfectly good ways to invest your hard-earned money so you can enjoy your golden years financially secure.
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Writer
Charlotte Edwards is an educator-turned-freelance writer based in Beijing, China. She writes personal finance and parenting content for both digital and print publications around the world.
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