Have you been stressing about which individual stocks you should purchase to try to increase your wealth? Mutual funds may be your answer. They offer instant investment diversification which means a lot less risk (and stress)! We are going to cover everything that you need to know if you want to start investing in mutual funds.
What is a mutual fund and how does it work?
Mutual funds are a professionally managed portfolio of stocks, bonds, or other securities. When you purchase a mutual fund, you are getting a more diversified holding than you would if you just held an individual security.
Mutual funds are divided into two types of funds – open and closed ended. An open ended fund doesn’t have a limit on the number of shares that can be issued by the fund. A close ended fund has a set number of shares.
Mutual fund distributions can be in many forms. These include capital gains, interest income, foreign source income or “taxable dividends”. A portion of a funds income will typically be paid out to the fund owners over the year (dividends). This will vary according to the fund but it’s typically monthly, quarterly, or annually. The distributions are generally taxed whether they are paid out in cash or reinvested.
What is a mutual funds NAV?
The price of the mutual fund is known as its net asset value (NAV). The NAV is determined by the total value of the securities in the portfolio, divided by the number of the fund’s outstanding shares. The NAV changes each day based on the value at market close of the individual securities held by the fund. If the NAV increases in value, but is not sold, then the fund’s units will increase in price.
What are the 6 types of mutual funds?
- Stock funds: these invest in stocks from many different companies. These are typically categorized by the size of the company that the funds invest in and the investment approach. Stock funds are the most common type of mutual fund.
- Index funds: index funds match one of the primary market indexes such as S&P 500 or Dow Jones Industrial Average. These are passive investments.
- Money market funds: these funds invest in short-term debt securities with high liquidity such as U.S Treasury Bills. They are low risk and low return.
- Hybrid funds: these funds have a mix of different asset classes. Hybrid funds usually invest in stocks and bonds. This approach tries to balance the potential growth of stocks with the stability of bonds.
- Bond funds: these funds contain investments that pay a fixed return rate. Some examples include government bonds, corporate bonds, high yield bonds, and certificates of deposit.
- Target-date funds: these funds are a combination of stocks and bonds. Investors can choose a year to meet their investment goal and the fund’s asset allocation will automatically adjust the closer it gets to that specific date. The fund’s may have a risker allocation early on and then become more conservative as time goes on.
What are the advantages of mutual funds?
- Diversification: Mutual funds can have a wide range of asset classes and industries. This allows you to have a diversified portfolio without needing to purchase a large number of individual stocks.
- Professional management: A professional fund manager will monitor your mutual funds portfolio. Knowing that you have an experienced manager who can watch and adjust the fund’s investments will take some of your financial stress away.
- Risk customization: Everyone has a different risk tolerance. This may also change over your lifetime. You can choose a mutual fund that matches your risk tolerance. For example, a young investor may want to invest in a mutual fund with high risk because they will have time to ride out market volatility.
- Affordability: There are low investment minimums which means that even small investors can take advantage of professional asset management and diversification.
- Liquidity: Mutual funds allow investors to buy and sell mutual funds on any business day.
What are the disadvantages of mutual funds?
When you invest in mutual funds, you should read the prospectus carefully to be aware of any risks. These are some ‘general’ disadvantages of investing in a mutual fund.
- Fees and expenses: The salary of the professional manager comes from the cost of the mutual fund and there may also be operational costs and fees that you need to pay. Fees can vary across different mutual funds so it’s important to be aware of what fees you will need to pay.
- Liquidity: If your mutual funds aren’t traded quickly enough, then you may not make your planned profit or you may experience a loss.
- Loss of Control: Your mutual fund manager will make all of the decisions about which securities to buy and sell. If you want to make the decisions yourself then mutual funds may not be the best option for you.
- Over-diversification: While diversification can reduce risk, it also dilutes profits earned by investors. Don’t invest in too many asset classes otherwise you may over-diversify your mutual funds.
Who should invest in mutual funds?
Mutual funds are suitable for a variety of different people at various points in their lives. They are generally preferred by investors who lack a large amount of money for investment, or those who don’t have the time to research the market, but want to grow their wealth.
Are there any fees for mutual funds?
There are a variety of fees that you may be charged for having a mutual fund. These can include sales load, expense ratio, redemption fees and transaction fees. A financial planner can help you understand what costs are associated with mutual funds and how they will affect your end goal.
What’s a good net expense ratio for mutual funds?
An expense ratio is an annual fee that is a percentage of your investment that goes toward the mutual fund’s expenses. For example, if you invest in a mutual that has a 0.5% expense ratio, you’ll pay $5 per year for every $1,000 invested. A good net expense ratio for mutual funds is usually less than 1% if you invest in large companies and less than 1.25% if you invest in smaller companies.
This money will come from your investment in the fund rather than you being sent a bill. This means that you need to keep a close eye on this to make sure that your net expense ratio is not too high. Even a small change in the net expense ratio can cost you a lot of money in the long run.
Do you pay taxes on mutual funds?
It’s important to know the tax implications for mutual funds. If you own mutual funds in a taxable account, such as a brokerage account, then you will need to pay capital gains tax when you sell shares of the fund if it has increased in value since purchase.
You also may need to pay taxes on shares sold within the fund even though these are not realized. The fund manager can buy and sell within the fund and you will be sent a tax form to report gains on your income taxes each year.
You will also pay yearly taxes on dividend payouts even if you reinvest them.
You can get around this by owning the funds in a tax-advantaged account such as a Roth IRA.
Which is better: active or passive mutual funds?
Most mutual funds are actively managed by an investment professional but it is possible to invest passively. Actively managed means that the investment professional does most of the heavy lifting and tries to beat the stock market’s average returns and take advantage of short-term price fluctuations.
Passive investors are usually invested for the long haul and have a “buy and hold” mentality. They don’t buy and sell as frequently as active investors which generally means that it’s a more cost-effective approach.
One approach is not necessarily better than the other. Only a small number of actively managed funds ever do better than passive funds. Talk to your financial advisor about which mutual fund investment strategy may be best for you.
How do you make money from a mutual fund?
You can make money from mutual funds in three different ways.
- Income is earned from dividends on stocks and interest on bonds. A mutual fund pays out nearly all of the net income it receives over the year in the form of a distribution.
- An increase in the price of securities. This is called capital gain.
- The fund share price (NAV) increases. The higher NAV reflects the higher value of your investment. If you sell your shares then you will make a profit. This is also called capital gain.
You are usually given the choice of whether to receive a payment for distributions or have them reinvested in the fund to buy more shares. Every decision comes with different tax implications so it’s important to discuss your options with your financial advisor.
Additional mutual fund questions:
- How do I purchase mutual funds?
Mutual funds can be purchased through a broker, a mutual fund company or a retirement plan such as your 401(k). Mutual funds are priced at the end of the trading day based on their net asset value (NAV). When you make a purchase then you will receive the next NAV. Most mutual funds have an investment minimum which is usually around a few thousand dollars.
- How do I sell mutual funds?
You can sell mutual funds the same way that you purchased them – through a broker or a fund manager. You will place a sell order and then you will receive the next available NAV. This means that you won’t know the price that you are selling until the trade goes through.
- Can I lose all of my money in a mutual fund?
While it’s unlikely that you will lose all of your money in a mutual fund, it is still a possibility. Investing in mutual funds with low volatility will help decrease the risk of losing all of your money.
- Are mutual funds low risk?
There is always some risk involved with investments, but mutual funds are one of the safer options. This is mainly due to diversification. They hold many company stocks within one investment which greatly reduces the risk of losing money.
- Is it a good idea to invest in mutual funds?
If you are looking to diversify your portfolio with minimal risk, then mutual funds may be a good idea for you.
- Can mutual funds make you rich?
While mutual funds may increase your wealth, it’s important to understand that there are risks with any type of investment. It’s important to stay invested for the long term to reap the benefits of any investment.
- What is the average annual return on a mutual fund?
The stock market has an average historical return of about 10% per year, according to the U.S. Securities and Exchange Commission. However, this only tells what you might expect your average return to be if you have total market mutual funds. Once you add in other types of mutual funds, it is hard to predict what the average annual return will be.
- What’s the difference between mutual funds vs ETF?
ETFs are investments that combine the diversification of mutual funds with the trading flexibility of securities. ETF and mutual funds are both collections of multiple securities. However, ETFs are bought and sold on a stock exchange so their pricing changes throughout the day. We discuss the key differences between ETF vs mutual funds here.
- What’s the difference between mutual funds vs index funds?
Index funds are a type of mutual fund. It aims to match the returns of a certain index such as the S&P 500 or the Dow Jones Industrial Average. The Vanguard 500 Index Fund is the first index fund to ever exist. Investors usually gain a small percentage annually and they don’t require regular buying or selling. Index funds are a passive investment and aren’t actively managed by a professional.
The main difference between index funds and mutual funds is that index funds are a passive investment that have steady returns and mutual funds are actively managed where the professional will try to beat the market.
Start investing in mutual funds today!
Mutual funds are a straightforward, affordable way to begin investing with a diversified portfolio. You can identify mutual funds that suit your goals, risk profile and timeframe. A financial advisor can help advise if mutual funds may be a good strategy for your investment portfolio. If you want help with your finances and are interested in having a comprehensive financial plan, feel free to schedule a discovery call with one of our financial advisors today!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.