How to Buy Mutual Funds
You’re looking into the stock market and trying to determine how to invest your money. For the sake of diversification, you are thinking of buying mutual funds instead of individual stocks to spread your risk around.
Mutual funds — which are baskets of securities — let you invest in multiple companies at a time. They’re a great way to bring diversification to asset allocation. Mutual funds can be used for investing in a short-term brokerage account or with long-term retirement planning.
Here’s an overview of how to buy mutual funds and some things to keep in mind when considering your investment options.
How to Buy Mutual Funds (5 Easy Steps)
- Form a Strategy
- Decide on Active or Passive
- Set Your Budget
- Explore Your Buying Options
- Build Your Portfolio
1. Form a Strategy
When you begin thinking about buying mutual funds, the first thing you’ll want to do is form a strategy and outline your investment goals.
Like with most investments, it pays to do some research and think about your personal situation before you dive into the market. By doing your due diligence, you can make informed choices that help you meet your investment needs.
Figure out Your Risk Tolerance
Conduct a self-audit and gain a high-level view of your finances. Try and gain an understanding of your risk tolerance, i.e., your appetite to absorb a bad investment.
This determines how heavily you should invest in mutual funds and other investments like stocks, index funds, and ETFs.
As you begin determining your risk tolerance, you will wind up in one of the following categories.
Most young investors fall into the aggressive category, as they have a higher risk tolerance and a longer time horizon for their investments. If you’re an aggressive investor, you will be able to handle market volatility, putting yourself in a position to make riskier investments that could produce higher returns.
An aggressive portfolio typically contains a mix of large-cap stocks, mid-cap stocks, and small-cap stocks, along with emerging stocks and securities like bonds.
If your risk tolerance is more middle of the road, you’ll still be able to weather some market volatility. However, you’ll want to be a bit more conservative in your investments.
A moderate portfolio may contain a mix of large-cap and mid-cap stocks, foreign stocks, intermediate-term bonds, and cash or money market investments.
If you have a low risk tolerance and a short time horizon, you’ll want to build a portfolio around stability, as you won’t be in a position to rebound from intense volatility.
In a conservative portfolio, the bulk of your investments will most likely be allocated toward intermediate-term bonds and cash or money market accounts. Minimize your investment in small-cap stocks or foreign stocks and only hold on to a smaller number of shares to reduce risk.
If you’re having trouble determining which category you fall into, consider talking to a financial advisor. Otherwise, you could wind up either exposing yourself to too much risk or building a portfolio that is too conservative to meet your needs.
2. Decide if You Want Active or Passive Investing
As an investor, you can either try to beat the market or mirror it by investing in funds that track benchmarks like the S&P 500.
Most mutual funds are actively managed, meaning they are designed to beat the market. They typically have an account manager who assembles the fund based on the stocks they believe give investors the biggest edge.
As a result, they are often more expensive, and they tend to be riskier due to the likelihood of human error. Be warned that less than half of mutual funds beat their benchmarks when you take management fees into account.
There are a few passively managed mutual funds. But most passive funds are either index funds or exchange-traded funds.
3. Set Your Budget
Once you have an idea of how to tackle the market, the next step is to analyze your budget and determine how much you want to put into mutual funds. It’s common for investors to put hundreds or even thousands of dollars at a time into mutual funds. How much you put into mutual funds largely depends on your situation and your goals.
When investing in mutual funds, it’s important to remember that share price is not the only metric to consider. For example, investing in mutual funds can sometimes have a higher barrier to entry than stocks, as mutual fund companies often require a minimum amount to invest in a fund.
For example, at the time of writing, the Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) had a minimum investment of $3,000.
Some mutual funds have a much lower minimum requirement, hovering in the $300 to $500 range. And some funds have no minimum investment at all. Shop around and you’re bound to find competitive funds that align with your budget.
4. Explore Your Buying Options
When buying stocks, you have to go through a brokerage firm like Schwab, TD Ameritrade, and Fidelity.
However, mutual funds come with a bit more flexibility. You can choose to buy them through a brokerage firm, or you can obtain them through an investment company like Vanguard or Morningstar.
Buying Mutual Funds from Brokerages
Buying mutual funds through a brokerage offers a few advantages. First, you’ll be given a broad range of mutual funds from many different providers to choose from, making it easy to compare them and determine which ones best suit your needs. Plus, you’ll be able to manage mutual funds alongside any other investments that you make through that online brokerage.
Keep in mind that brokerage firms can offer high fees for mutual funds. If you’re not careful, you could wind up paying brokerage fees on top of mutual fund fees. This is why it’s so important to look for places where you can make no-transaction-fee investments.
Buying Mutual Funds from Investment Firms
The other option is to go directly to mutual fund providers like BlackRock or MFS Investment Management.
This option could result in lower overall fees, meaning more of your investment is going to be put toward growth. However, you won’t find the same selection that you can expect from a brokerage firm.
For example, BlackRock doesn’t offer funds from competitors (e.g., Vanguard). However, there is nothing stopping you from buying funds from two or more providers as long as you keep track of them and stay organized.
5. Build Your Portfolio
The final step is to start looking for mutual funds and adding them to your portfolio.
Find Affordable Mutual Funds
Mutual funds can be expensive. Jumping headfirst into a mutual fund without reading the prospectus — or account overview — could result in some unexpected surprises after the sale.
Mutual funds can contain front-end loads, which are paid for at the time of the sale, and back-end loads, which occur when you sell the fund.
Read the fine print and analyze past performance before picking up any mutual fund shares.
Check the Expense Ratio
One way to get a quick sense of a mutual fund’s cost is to look at the expense ratio, which indicates how much of your investment goes toward growth versus account management.
Going back to the VBTLX example, you’ll see that the current expense ratio is 0.05%. According to Vanguard, the average expense ratio of similar funds is 5%. So if you invest $10,000 over the course of 10 years, you’ll save roughly $781 by their estimate.
As you can see, an expense ratio may not seem like a big deal at first. But it can add up over time. Every dollar spent on fees is a dollar that’s not working to build your financial wealth. So it definitely pays to find low-cost mutual funds.
Manage Your Portfolio
As an investor, you don’t have to do too much when it comes to managing a mutual fund. Investing in a mutual fund is a pretty hands-off strategy — especially if you’re working with a fund manager. However, it’s a good idea to keep an eye on the account to see how it’s performing over time and whether it’s keeping you on track to reach your goals.
Consider rebalancing your portfolio on an annual basis. Move investments around to maximize your returns and push back against volatility.
Tips for Buying Mutual Funds
Pick Funds Based On Their Asset Class
Mutual funds are highly diverse and they can fall into several subcategories.
Equity funds invest in shares of publicly traded companies. Equity funds typically produce a higher yield but come with a heavier risk. As such, they are better suited for aggressive investors.
Money Market Funds
Money market funds are based around short-term liquid debt instruments. They are typically very low risk but offer limited returns.
Debt funds include fixed-income assets and government bonds. Just like money market funds, debt funds are considered to be very safe.
Index funds are based around the movement of stock exchanges (e.g., the S&P 500), meaning the fund performs based on how the market does.
Funds of Funds
Funds of funds invest in other mutual funds instead of individual securities.
Watch out for High Turnover Ratios
In addition to the expense ratio, you should also look at the fund’s turnover rate or the amount of the portfolio that is bought and sold annually.
This only applies if you are investing in a brokerage fund, instead of a retirement fund like an IRA. Funds that have higher turnover ratios incur higher capital gains taxes. The lower the turnover ratio, the less you may pay in fees.
Be Selective About Who is Managing Your Fund
If you’re paying a portfolio manager to oversee your investment, make sure that individual has a demonstrated history of success. The last thing you want to do is put a major investment in the hands of a rookie investor or someone with a history of incurring losses.
Check their performance through up markets and down ones as well and see how they compare to the benchmark. Are they generally earning their fees? Obviously, past performance is no guarantee that they’ll have similar results going forward, but it’ll give you a sense.
You may also want to inquire about whether the fund manager is personally invested in the account that you’re considering. If the fund manager has a direct stake in its performance, they may be more apt to make honest and savvy decisions.
Know How to Benchmark the Fund
Understand how the fund is put together before you invest in it. In some cases, balanced funds with a mix of equities and securities can produce returns that are lower than market averages. However, it may not necessarily indicate that the fund is underperforming.
So before you judge a mutual fund and write it off as a bad investment, check to see if it’s actually performing poorly or whether you need to adjust your expectations based on its composition.
That said, there’s no requirement that you buy a mutual fund. If the fund isn’t matching the returns of a low-cost index fund, skip the fees and take the money.
Focus on Building a Diversified Portfolio
If you’re like most investors, mutual funds should only comprise a portion of your overall portfolio. You also want to invest in individual stocks, ETFs, real estate, and bonds — even if you’re already investing in these securities through mutual funds.
For example, you may invest in a mutual fund based on the technology industry. Then you may turn around and invest in a company like Apple directly — even if it’s already included in the fund. Investors often do this to drive larger returns based on companies they like.
Frequently Asked Questions
Are mutual funds useful for retirement planning?
Mutual funds can make an excellent addition to a retirement fund, like an individual retirement account (IRA) or Roth IRA. They are often used to achieve balance and offset market volatility.
What is a no-load mutual fund?
A no-load mutual fund is one where shares are sold without a sales charge or commission. This is possible because shares are distributed by the investment company instead of a third-party provider.
What is an intermediate-term bond fund?
An intermediate-term bond fund is a type of bond fund that is built around intermediate-length bonds, which mature between 5 and 10 years. Mutual funds can also be broken down into short-term bond funds and long-term bond funds. In general, longer-term bonds have higher yields than shorter-term bonds.
How are mutual funds taxed?
Taxes are paid on mutual fund earnings or gains when you trigger a taxable event. For example, if you are using a taxable brokerage or investment account, you’ll need to pay taxes whenever you profit from the sale or exchange of a mutual fund. Further taxes may also accrue should the mutual fund pay dividends. Keep in mind though that capital losses can offset capital gains.
Talk to a tax advisor if you’re investing in mutual funds to avoid overpaying on taxes. Mutual fund taxes can be complicated. As such, it can be a good idea to get a professional third-party opinion.
What are target-date funds?
Target-date funds are retirement plans that change as time passes and your financial situation changes. They are designed to automatically rebalance as you inch closer to retirement age, shifting away from equities and becoming more heavily geared toward cash equivalents and securities.
What is a mutual fund’s NAV?
Net asset value (NAV) refers to the value of a fund’s assets less the value of its liabilities. NAV is calculated by dividing the total value of a fund’s securities and cash minus its liabilities by the number of outstanding shares. Investors look to the NAV to determine the book value of the mutual fund.
The Bottom Line
Investing in mutual funds is something that any investor can do, regardless of age or financial status. Whether you’re a young investor who is just starting out or a seasoned investor who is planning for retirement, mutual funds can help diversify your portfolio and drive growth.
As you learn the art of picking the best mutual funds, don’t be afraid to ask for help from certified financial professionals. Tax experts can help guide your decisions while minimizing risk and lowering expenses.
As a beginning investor, it’s often very difficult to pick the right funds on your own. Oftentimes, investors skip mutual funds altogether and put the bulk of their money into stocks or ETFs because they don’t know what they’re doing.
Remember: Investing is a learning experience. It pays to ask for help and to lean on people who have done this for decades. In time, you’ll get the hang of managing your own portfolio.
It’s also important to remember that mutual fund investors need to be patient. Mutual funds don’t typically produce the explosive short-term gains that some stocks offer and they can take time to pan out.
One of your primary investment objectives should be to practice patience and avoid making rapid moves out of gut instinct whenever possible. Form an investment strategy and stick to it, and your investment portfolio is most likely going to perform better over time. It’s that simple.