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How to Invest in Mutual Funds

Jun 03, 2021 4 min read Casey Bond

Key takeaways

  • Mutual funds offer a great way to access well-diversified, professionally managed investment portfolios.
  • It’s important to understand the fees involved, as they eat into returns.
  • Investing through a retirement account offers tax advantages and other benefits.


Learning how to invest in mutual funds can help you reach your financial goals, even if you’re just getting started. It’s important, however, to understand how they work before you lay your money down.



What are mutual funds, and how do they work?

A mutual fund takes a pool of individual investments, such as stocks, bonds or other securities, and packages them as a single investment. A stock fund, for example, allows you to own a tiny sliver of many stocks at once. What’s more, it enables you to diversify across the asset class, or investment type: Instead of pinning your hopes on the movement of a few stocks, you spread your risk among tens, hundreds or even thousands of companies, which reduces the chance that trouble with one or two will sink your whole investment.

A professional manages this pool of money, and investors all own shares that represent their slice of the larger pie. Exchange-traded funds (ETFs) also do this. The key difference: Unlike mutual funds, which you buy through a broker or the fund company itself, ETFs trade on exchanges like stocks.

A mutual fund’s net asset value (NAV) represents the value of its shares; unlike ETFs and individual stocks or bonds, whose prices change throughout the day, a mutual fund’s NAV is set each day after the market closes (usually 4 p.m. ET). In fact, when you place an order to buy or sell fund shares, it won’t go through until 4 p.m. ET—and if you place the order after 4 p.m., it won’t be executed until after market close on the following day.

Each mutual fund has a prospectus that outlines its objectives and “investing style,” or the types of investments it seeks to hold. This can be anything from mid-size U.S. company “value” stocks (whose shares are considered underpriced) or emerging-market energy stocks (who could face specific supply and demand or other pressures) to corporate high-yield (aka “junk”) bonds or U.S. Treasury bonds.

The fund’s manager (a person or team) may “actively” manage the fund, buying and selling investments in an attempt to outperform similar funds. On the other hand, “passive” (aka “index”) funds try to match the performance of a particular “benchmark” index, or group of investments that represent a segment of the market (like the S&P 500®, which reflects the 500 largest stocks in the U.S.).


How to make money from mutual funds

Before you learn how to invest in mutual funds, it’s good to get a grasp of how you can make money with them. Not all mutual funds are created equal—some come with more risks and fees than others.

In general, mutual funds can generate money for you in two ways: capital gains and dividends (for stock funds) or interest (for bond funds).

When you sell fund shares that have appreciated, or grown, in value, you’ve earned capital gains. That’s a good thing, but it means you’ll owe taxes on that profit unless you’re investing through a tax-deferred retirement account like a 401(k) or IRA.

There are two types of capital gains:

  • Short-term gains. If you buy and later sell mutual fund shares within one year, any gains are considered short term. They’re taxed as regular income.
  • Long-term gains. If you hold your shares for longer than a year, any gains you “realize” when they’re sold are considered long term. These are currently taxed at 0%, 10% or 20%, depending on your income.

The investments that stock funds hold also often pay dividends, a form of profit-sharing for companies that are doing well financially. You can choose to have the dividends distributed to you or reinvested back into the fund. Keep in mind that dividends are taxed as ordinary income unless the fund holds the dividend-paying stock for a specified length of time (usually at least 61 days) before the stock pays out new dividends. In such a case, the IRS considers those dividends “qualified,” which means they’re taxed at long-term capital gains rates.

By contrast, interest you receive from bond funds is taxed as regular income, much like interest you earn from a bank account. (When you sell bond fund shares for more than you paid, though, you face capital gains tax on the profit.)


Risk vs. reward

How much you earn from a mutual fund will depend largely on how much risk it takes. Here’s where the basic rule of investing applies: The greater the risk, the greater the potential reward—but also the greater the chance of losing money, at least in the short term.

Mutual funds’ risk profiles vary depending on the types of investments they hold. For example, a fund that invests in a wide swath of large U.S. company stocks will have less risk over time than one that invests only in new technologies. In any given year, though, the tech fund could outperform the large company fund.

Even so, note that all mutual funds face investment risk, so you should chose those that match your own tolerance for and ability to take on risk.


Watch the costs

Also, closely examine a fund’s fees, which eat away at your returns. Since someone manages a mutual fund, they pass on their operating costs to investors in the form of an annual fee known as an expense ratio. This fee reflects the percentage of your investment that goes to pay for the fund. If a fund’s expense ratio is 0.5%, for example, the fee would equal $50 for every $10,000 invested.

Some funds also have sales “loads,” or fees that kick in when you buy or, less commonly, sell shares. And some charge “12b-1” fees that cover costs of marketing the fund to people like you. Also, if you’re using an investment advisor, they may receive a portion of your investment as commission for moving you into the fund.

All told, these fees take a bite out of your annual returns—and even small bites can have a huge effect over time. So, it’s often prudent to invest in mutual funds with low fees and no sales loads.

What’s more, because managers of passive (index) funds already know what to invest in and in what proportions, they don’t need you to pay for the research and staff required to run active funds. So, index funds generally charge less in fees.


How to start investing in mutual funds

If available, a workplace retirement plan (like a 401(k) or 403(b)) is a great place to start a mutual fund investing strategy. If you don’t have access to an employer-sponsored plan, you can invest in mutual funds through an individual retirement account (IRA).

All of these accounts have major advantages. For one, you’ll experience tax-deferred growth on your investments. Also, you can make pretax (for traditional workplace plans) or tax-deductible (for IRAs) contributions—or get tax-free withdrawals if you choose a Roth account and meet certain criteria). And if your employer offers a match on contributions, that’s additional (free!) money that you can use to buy more shares.

You can also purchase mutual fund shares within a taxable investment or brokerage account—or directly from fund companies themselves. This will have fewer tax advantages, and you may owe taxes even in years when you don’t sell any shares. The reason: The fund itself buys and sells investments throughout the year—and passes any tax bills on to you.


What you can do next

Devise a strategy for incorporating mutual funds into your financial life. Consider how much money you have available to invest, your risk tolerance, and what type of account you want to hold your funds in. (It’s okay to start small, but try to set up regular, automatic contributions.) If you need help determining which funds to buy, reach out to an advisor near you who can help.


Casey Bond is a seasoned personal finance writer and editor as well as a Certified Personal Finance Counselor® (CPFC). Her work has appeared on HuffPost, Business Insider, Yahoo! Finance, MSN, Forbes, The Motley Fool, U.S. News & World Report, TheStreet and others.


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