Understanding Mutual Funds
A simple and efficient way to start investing
Rather than investing in an individual stock or bond, many investors choose to invest in mutual funds. A mutual fund is a company that pools money from many investors and invests in a broad range of securities, depending on the goal of the fund. Just like you, a mutual fund can choose to buy stock in companies, invest in bonds or cash, or select a combination.
The advantages of mutual funds
A big advantage of a mutual fund is that it can give you automatic diversification, meaning you can be automatically invested in several companies or industries—without having to do the work of choosing individual stocks. It’s also professionally managed, so you don’t have to spend time following the day-to-day happenings in the stock market.
But you do have to know which fund to pick. Here are some things to consider.
Types of mutual funds
There are many types of funds, with varying investment styles. And each fund carries a different level of risk and return. Here are the main types of funds:
- Index funds are good options for both first-time and seasoned investors. Each of these funds comprises a portfolio of stocks that attempt to mimic the performance of a specific index, such as the S&P 500® Index or the Wilshire 5000 Index. In addition to providing diversification, index funds can be attractive because of their relatively low fees.
- Actively managed funds have managers who invest with hopes of beating the benchmark. Performance varies greatly depending on the type of fund and its manager, so you have to be sure to choose carefully.
- Stock (or equity) funds invest in U.S. or foreign stocks. There are many different stock funds, with a wide variety of risk levels associated with them.
- Bond funds typically invest in corporate, municipal or government bonds. They are further classified by whether they are taxable or nontaxable. These types of funds are usually conservative investments.
- Money market funds generally invest in cash equivalents such as U.S. Treasury bills and CDs. They are lower-risk investments and tend to offer better returns than savings accounts, but they are not insured by the FDIC.
- Blended or balanced funds invest in stocks and bonds with the goal of achieving both investment growth and stability.
- Target-date or life-cycle funds are mutual funds that shift asset allocation as your target date for needing the money draws near. These are great options for people who want a single investment and don’t want to have to rebalance their portfolios frequently. They can also be a good choice for retirement investing.
Tips for choosing a mutual fund
There are a number of things to consider when choosing a mutual fund. Here are the top four to help you get started:
- Start with broad-based mutual funds. This will to help ensure the right amount of diversification.
- Consider no-load funds with no transaction fees. You don’t want to pay sales charges if you don’t have to. Watch out for other fees such as operating expenses. High fees can really eat into your returns.
- Choose funds with steady performances and solid track records. Measure a mutual fund’s performance against an appropriate benchmark. For example, you could compare the performance of a large-cap mutual fund with the S&P 500 Index. Keep in mind, though, that past performance is no indication of future results.
- Consider the tax implications of mutual funds. Taxes can have a big impact on returns. For instance, funds right for a tax-deferred account like an IRA may not be right for a taxable account. Learn more about tax-smart investing.
Not all mutual funds offer broad-based diversification. For example, some funds invest in a single industry or sector. Keep this in mind as you choose funds.
Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Bond funds are subject to increased loss of principal during periods of rising interest rates.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The information on this website is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.