How to Invest in Mutual Funds and Diversify Your Portfolio

Have you considered investing in mutual funds but could never get started? Financial jargon and choosing the best mutual funds discourage many potential investors. That’s why we’ve put together these simple steps to get you on your way.

As of 2023, it is estimated that global mutual fund assets exceeded $60 billion, according to research by Valuates. Mutual fund investments have grown steadily over the years with millions of participants.

Keep reading to find out about the different types of mutual funds, including the likes of Vanguard and Fidelity.

“The mutual fund industry has been built, in a sense, on witchcraft.” 

  • John C. Bogle, Founder of the Vanguard Group

Reflecting on the many false notions in the industry, Bogle underscores that investors must understand how mutual funds function and the importance of choosing the right funds.

Key Takeaways

  • Mutual funds provide diversification, which is critical for risk management. They help to reduce the negative effect that may result from one asset’s poor performance by spreading investments across various assets.
  • Fees associated with mutual funds, including management fees and transaction costs, differ greatly and can significantly affect long-run investment income.
  • When contrasted with active fund management, passive mutual funds usually have lower fees, hence being appropriate for cost-conscious clients.
  • Digital platforms have led to the democratization of access for individuals to money market accounts, thereby cutting out the intermediaries and resulting in cost savings.

What Is a Mutual Fund?

A financial vehicle known as a mutual fund pools money from many investors into one entity. This pool will then be used for purchasing a diverse group of securities, from stocks to bonds to others.

Individual investors primarily utilize mutual funds to access diversified, professionally managed portfolios. This diversification ensures that investment risks can be effectively managed since the performance of one security does not significantly affect performance at large.

But how do mutual funds work?

How Do Mutual Funds Work?

When you invest in a mutual fund, you’re actually buying shares of the fund. These shares can go up or down in value depending on how well the securities in the portfolio perform.

Each mutual fund has a fund manager (Mutual fund manager) who makes decisions about how to allocate the fund’s assets, striving to produce capital gains or income for the fund’s investors.

The combined holdings of the mutual fund are known as its portfolio, and each share represents an investor’s part ownership in the fund and the income it generates.

Each type of fund has its own strategy and risk level, making it essential to align your choice with your investment goals and risk tolerance.

Why Invest in Mutual Funds?

Before digging in any further, a key question arises: why choose mutual funds over other investment options?

There are six reasons that make them a compelling choice for investors looking to expand their portfolios, particularly for those who are new to investing.

In short, mutual funds offer:

Advantages of Investing in Mutual Funds

The greatest advantage of mutual funds is that they offer diversification.

Mutual funds pool money from many investors to invest in a wide range of securities. Diversification works by spreading out risk so that if one or two investments fail to perform as expected, the others will compensate for their loss. It’s a way of spreading out investment risk because the performance of a fund does not depend solely on one stock or bond.

Another aspect to consider is professional management. Professional managers run mutual funds; these managers are experienced investment professionals. They make informed decisions about what securities to buy and sell based on their analysis, with an aim to maximize returns for investors. Such management could be vital, particularly for beginners who may lack the time or expertise required to manage personal portfolios themselves.

Mutual funds are an affordable way to invest your money and gain diversified holdings. Many of these funds allow a small minimum investment, making them accessible to many types of investors.

This is important to know if you decide to utilize a tax-deferred pension scheme for mutual fund investing. Note that taxes depend on personal circumstances and are subject to change.

Mutual funds also offer liquidity, meaning you can easily convert your investment into cash. This is particularly useful in case you need to access your money quickly.

Furthermore, mutual funds provide a way to participate in a range of investment strategies and asset classes, from growth stock mutual funds to bond and money market funds.

Active vs. Passive Mutual Funds: Characteristics and Comparison

One of the big decisions for you to make revolves around choosing between active and passive funds, both of which have their pros & cons and a potential role to play in your portfolio.

Active Mutual Funds

Characteristics of Active Funds

These are characterized by active management. Here, fund managers and their teams make specific investment decisions, aiming to outperform the market or a specific benchmark. They frequently buy and sell securities, attempting to capitalize on market trends and price fluctuations.

Pros and Cons of Active Funds

Pros

  • Potential for higher returns
  • Personalized investment strategies

Cons

  • Higher fees
  • Potential for underperformance compared to benchmark indices

Active funds might appeal to those who believe in the skill of professional managers to beat the market despite the higher fees.

Passive Mutual Funds

Characteristics of Passive Funds

In contrast, passive mutual funds mirror the performance of a market index, such as the S&P 500 or FTSE 100. The idea is not to beat the market but to replicate its performance, thus benefiting from the market’s overall upward trajectory over time.

Pros and Cons of Passive Funds

Pros

  • Lower fees
  • Reduced risk of human error in trading
  • Typically more predictable outcomes

Cons

  • Limited potential for outperforming the market
  • Entirely dependent on market movements

Passive funds usually attract those who prefer a more predictable, cost-effective investment aligned with market trends.

Active vs Passive Fund Flows

In recent years, funds flow analysis has consistently indicated a growing preference for passive funds over their active counterparts. This trend can be attributed mostly to the lower costs and stronger historical returns of passive investing.

Active vs Passive Fund Flows

How to Start Investing in Mutual Funds

Knowing how to invest in mutual funds for beginners can be intimidating. Nevertheless, breaking it down into simple steps can make it easier and more manageable.

1. Choosing the Right Investment Strategy

Your first move should be defining your investment strategy. This will involve determining what duration or risk level works best for you.

Are you interested in long-term investments, or do you like medium- or short-term strategies?

Long-term strategies usually carry less risk and are most suitable for goals such as retirement savings, while short-term ones may target faster gains, albeit at higher risks.

2. Researching Potential Funds

There are a number of third-party websites that provide free fund research tools and scanners, including Morningstar Instant X-Ray, WSJ Mutual Fund Screener as well as BankRate’s Mutual Fund Expense Calculator to act as a guide on how to invest in mutual funds online.

You could also check directly on the websites of fund management companies such as Fidelity, Blackrock, or State Street for how to invest in direct mutual funds.

Your choice of fund should rest on a combination of the following factors:

  • Performance History: While past performance does not guarantee future results, it provides an indication of how well a fund has handled different market environments.
  • Fund Management: Look into the fund manager’s experience and track record.
  • Expense Ratio: It represents annual charges expressed as a percentage value attached to assets. Low expense ratios make big differences over time in terms of returns on investments.
  • Investment Objective: Make sure that the fund’s objective matches your own investment plan.
  • Risk Level: Assess its riskiness using both professional ratings and personal assessment against your tolerance levels.

3. Opening an Account

A mutual fund investor must have an account through which they can buy the units. These are available from brokers, banks, and online platforms.

If you already hold a brokerage account, then this could facilitate mutual fund investing. Otherwise, web-based brokers offer a wide variety of funds, often with lower charges.

4. Watch Out for Fees

Fees that come with mutual fund investing are well worth taking the time to understand. They usually include:

  • Sales Loads: These are fees paid when buying or selling shares of a mutual fund.
  • Redemption Fees: Often incurred if one withdraws money within a specific period.
  • Account Fees: They incur from managing your account.

Understanding these kinds of costs is very important, especially over time, as they might detract from your investment returns.

5. Keep an Eye on Fund Performance

After you have invested in funds, you should constantly keep watch over them. That does not necessarily mean observing the stock market every day but rather understanding how well it has done in comparison with what you wanted it to achieve.

Depending on changes occurring in personal finances or the markets themselves, adjustments may be necessary.

Exploring the different types of mutual funds

Mutual funds are categorized based on the types of investments they hold. Each category serves different investor needs and follows distinct strategies and risk profiles.

Let’s explore some of the most popular types of mutual funds, highlighting some specific mutual fund examples.

Stock Mutual Funds

These funds invest primarily in stocks and are often categorized based on the company size, the investment style of the holdings (growth vs. value), or the geographical location.

For example, how to invest in growth stock mutual funds? A large-cap growth stock mutual fund focuses on large, well-established companies with a potential for growth.

Example: Vanguard Total Stock Market Index Fund. Vanguard mutual funds are well known, with this one particularly popular for its wide diversification and low costs, making it one of the largest mutual funds to invest in.

Index Mutual Funds

These funds aim to replicate the performance of a specific index, like the S&P 500. They are typically passive, meaning they have lower expense ratios.

Example: Schwab S&P 500 Index Fund SWPPX is a mutual index fund tracking the S&P 500 Index.

Bond Mutual Funds

These funds invest in various debt securities. The risk and return of these funds depend on the stability of the issuers of the debts, like governments or corporations, and the duration of the bonds.

Example: PIMCO Total Return Fund is a notable name in this category, offering a mix of bonds with a strategy aimed at capital preservation and income.

Money Market Funds

Money market funds invest in highly liquid, short-term instruments, such as government bonds or Treasury bills. These are considered one of the safest mutual fund investments.

Example: Fidelity mutual funds, such as SPRXX Fidelity Money Market Fund. are significant players, offering liquidity and stability with low-risk investments.

Investing in Mutual Funds vs Stocks

The following table provides a basic comparison of mutual funds and stocks, helping you understand the fundamental differences in management, risk, potential returns, and other key aspects.

Comparison Mutual Funds Stocks
Diversification Offer built-in diversification through a collection of various assets. Concentrated on the performance of a single company.
Management Managed by professionals providing expertise in selecting a mix of assets. Self-managed or requires a separate account manager.
Minimum Investment Typically have a lower minimum investment requirement, making them more accessible. Can require higher capital, especially for well-known companies.
Risk Lower risk due to diversification, but depends on the type of mutual fund. Higher risk as it depends on the performance of a single company.
Costs Incur management fees and, in some cases, sales charges. Transaction fees per trade; no ongoing management fees.
Liquidity Generally easy to buy and sell but based on the fund’s net asset value (NAV) at the end of each trading day. High liquidity, can be bought and sold during trading hours.
Potential   Returns Potential for steady returns aligned with market or specific sector performance. High potential for returns but also a higher risk of loss.
Control Investors have limited control over the specific holdings in the fund. Direct control over which stocks to buy and sell.
Research Required Less intensive, as the fund is managed by professionals. Requires in-depth research to make   informed decisions.

Investing in Mutual Funds vs. ETFs

This comparison table highlights the primary differences between investing in ETFs and mutual funds, particularly in terms of trading, costs, and tax implications.

Comparison Mutual Funds ETFs
Trading Bought and sold at the end of the trading day at the Net Asset Value (NAV). Traded throughout the day on stock exchanges, like stocks.
Pricing Priced once a day after the market closes. Prices fluctuate throughout the day, based on supply and demand.
Investment   Minimum Typically have a minimum investment requirement. Can be bought in single share increments, no minimum investment.
Management   Style Can be actively or passively managed. Most ETFs are passively managed, tracking a specific index.
Costs Usually have higher expense ratios, especially for actively managed funds. Generally lower expense ratios due to passive management.
Tax Efficiency Less tax-efficient due to potential capital gains distributions. More tax-efficient, especially when it comes to capital gains taxes.
Liquidity Liquidity is based on daily NAV, but redemption can take time. High liquidity, similar to stocks, allowing for quick buy/sell transactions.
Diversification Offer diversification; varies based on fund type and objective. Typically provide broad market exposure and diversification.
Dividend Reinvestment Automatic dividend reinvestment is common. May or may not offer automatic dividend reinvestment.

Challenges of Investing in Mutual Funds

Like any investment, mutual funds have their disadvantages too.

  • Diluted gains: Having your money pooled into these diversified portfolios could mean diluted gains as high-performing stocks are watered down by other securities in a portfolio.
  • Management fees: Net returns are also reduced by management fees and operational costs, which can vary widely across funds.
  • Market risk: Mutual funds also face the market risk that is part of any investment. In addition, there may be a minimal investment required for mutual funds, which might hinder some investors.
  • Performance tracking:  Monitoring the performance of your mutual fund investments can sometimes be challenging due to changing fund composition.

The Bottom Line: Should I Invest in Mutual Funds?

Investing in mutual funds you benefit from professional management and diversification. Before choosing a mutual fund, it’s important to consider the differences between active versus passive investing styles and what best suits you and your investing objectives.

There are numerous mutual funds available on the market, and the best mutual funds to invest in will be those which align with your investment strategy.

The best way to invest in mutual funds from the point of view of just getting started is by using an  online platform, which makes it easier than ever to invest directly into mutual funds.

However, you need to consider costs, set clear goals, and assess your own risk tolerance before making any investment decisions.

Do your own research and always remember your investment decision depends on your attitude to risk, your expertise in the mutual funds market, the spread of your portfolio, and how comfortable you feel about losing money.

The information in this guide does not constitute investment advice and is meant for informational purposes only.

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Jasper Lawler
Financial expert

Jasper cut his teeth on Wall Street as a stockbroker and honed his analytical skills with the City of London's top trading firms. Today, he applies his financial expertise to content creation as the founder of Trading Writers, a niche content marketing agency for the finance sector. Jasper's articles can be found on Techopedia, Seeking Alpha, UK Investor Magazine, Trade2win, Investing.com, FXStreet, Trading212.com, FlowBank.com, and Capital.com. His analysis has been quoted in prestigious publications such as the Financial Times, Bloomberg, Reuters, AFP, and City AM. Jasper's transition from stockbroker to content creator highlights his deep understanding of the financial markets…