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- Mutual funds do the research and diversification for you.
- You can invest in similar types of stocks or bonds — or track large swaths of either market.
- Expenses, turnover and risk can affect your returns.
When it comes to investing, diversification is crucial. Spreading your risk among lots of investments can help you ride out the market’s ups and downs. But buying individual stocks and bonds can be more time-consuming, costly and risky than you bargained for. Luckily, you don’t have to know how to pick, choose and manage individual investments. You can get a piece of hundreds or even thousands at a time with mutual funds.
Mutual Fund Definition
Mutual funds are professionally managed pools of stocks, bonds and sometimes other investments. When you invest in a mutual fund, you buy shares — tiny slices of a giant pie — either through a broker or directly from the fund company. Share prices, aka net asset value (NAV), are set once a day after the market closes. And most mutual funds are “open-ended,” so the number of shares you can buy is almost limitless.
Funds are typically designed so their investments will work together. That might mean a narrow collection of small-company “value” stocks (those managers consider underpriced). Perhaps it’s a broad group of stocks designed to mimic a major market index, like the S&P 500 for large U.S. company stocks or the MSCI for stocks around the world. Or maybe it’s a mix of stock, bond and cash investments that grows more conservative as you approach your goal — say, the year you plan to retire. (Those are called, fittingly, target-date funds.)
Mutual fund managers take one of two general approaches: active and passive. Actively managed funds try to outperform their category peers — and generally charge more for the research, buying and selling that takes. Meanwhile, passively managed (aka index) funds aim to match the performance of their “benchmark” index; because they already know which stocks or bonds are in the index, and the percentages they comprise, these funds charge less in management fees.
How to Invest in Mutual Funds
Here are some things to note as you’re researching mutual funds:
- Is there a sales load? Some mutual funds charge a fee when you buy in, while some ding you on the way out if you don’t hold the shares for a set period; other funds, called no-loads, do not.
- What’s the expense ratio? This is the cost to run the fund — paid by you — so the lower it is, the more of your earnings you get to keep. For instance, a 1% expense ratio means that for every $1,000 you invest, the fund will deduct $10 a year from your returns. Actively managed funds tend to have higher expense ratios than passively managed (index) funds.
- What’s the rate of turnover? Unless you’re investing through a tax-advantaged account like a 401(k) or IRA — or you own shares in a tax-free municipal bond fund — how often the manager buys and sells investments can have a big effect on your tax bill.
- What’s the risk? Besides focusing on stocks (generally riskier with higher potential returns) versus bonds (typically less risky but with less potential reward), there are dozens of stock and bond sub-categories with different risk/reward profiles. Some mutual funds invest conservatively and are more appropriate for money you’ll need in the next few years. Others are more aggressive, subject to wide fluctuations and more fitting for money you can leave there for the long term.
- What’s the minimum investment? Some funds require a minimum amount to start, such as $1,000 or $3,000. But you may be able to bypass that by setting up regular, recurring deposits.
- What’s the manager’s track record? With actively managed funds, find out how long the manager or team has been in charge, how they’ve performed versus their peers, and whether they’ve strayed from their stated investment strategy or “style.” (This is less important for passively managed index funds.)
What Can You Do Next?
Talk to your financial advisor about your goals, how much you plan to invest and how comfortable you are with risk. (Try this tool to calculate how much you can comfortably sock away.) Your advisor can help you choose a fund — or a selection of them — to help you meet your short- and long-term objectives.
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