A Guide to Investing in Mutual Funds
We all want to choose the wisest investments from the opportunities available to us. Professionals and experts in the field of financial management have long advocated for investors to diversify their portfolios. One of the simplest ways to do so is to investigate mutual fund investment.
Do you really know how mutual funds work? Unlike other types of securities, you will want to have a clear understanding of what you truly own when it comes to buying mutual funds.
A mutual fund investment should be supported by plenty of research regarding the types of mutual funds, mutual fund fees, and specifics on which funds are highly rated.
In our detailed mutual fund investment guide, AdvisoryHQ wants to make sure you know all of the basics. We’ll start with a clear mutual funds definition and move on to how to purchase top funds that are expected to perform well over the coming years.
If you’re ready to start learning the ins and outs of how mutual funds work, it’s time to start looking at the mutual funds definition.
Mutual Funds Definition
It isn’t hard to put together an easily understood mutual funds definition. In fact, it can be summed up in just a few words: a mutual fund is a collection of stocks and bonds that a group of people invests in together.
Image Source: The Balance
The mutual funds definition might be relatively simple, but it’s important to make sure we truly understand what it means. Diversification is one of the biggest principles for how mutual funds work with a collection of securities across different market sectors. It gives investors access to some stocks and bonds that they may not be able to purchase without pooling money together with others.
When you make a mutual fund investment, you are purchasing “shares” instead of the securities themselves. Your share in the mutual fund investment does not entitle you to any of the specific securities that comprise that fund. This is a key component to how mutual funds work.
What you invest in is only a portion of the entire holdings of the fund.
If you don’t own the securities themselves, how do you make money on your mutual fund investment? Income can be generated from good mutual funds in a few key ways:
- Through dividends and interest earned on the securities within the mutual fund
- Through selling securities at a capital gain (for more than what was originally paid)
- Through selling your shares in the mutual fund if the holdings increase in price
These can be purchased through any number of avenues: your local bank, a financial advisor, or through trade sites. One of the best parts of a mutual fund investment is that they typically require very low initial investments and only monthly maintenance payments to continuously increase your holdings. Specific requirements for investments will vary based on the fund itself.
Understanding the mutual funds definition is only a small part of knowing how to make a smart mutual fund investment. There are specific advantages and disadvantages closely linked to how mutual funds work. These advantages are also important to understand so you can select good mutual funds.
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Advantages of a Mutual Fund Investment
The biggest advantage to a mutual fund investment is the ability to quickly diversify your holdings. For beginner investors especially, it’s a good idea to spread out the money that you can plan to invest across different market sectors, companies, and types of investments. The specific amount of diversification will vary according to the different types of mutual funds you can purchase.
When you diversify your holdings, you minimize some of the risk inherent to investing. Losses from one holding are offset by gains in another to help balance out the money that you have put into your mutual fund investment.
Often, the securities within good mutual funds tend to be pricier per share and out of reach for a typical investor. By pooling your money together with others to create good mutual funds, you can own shares of these pricier and sometimes better-performing stocks and bonds. This is one of the best parts that is absolutely inherent to the mutual funds definition.
Not only is buying mutual funds advantageous for these reasons, but you can also sell your shares quickly if you need to. Some investment types, such as certificates of deposit, require you to leave your money where it is at for a specified period of time. When you’re investing in mutual funds, you have a high degree of liquidity to take your money back if you need to.
The last major advantage to a mutual fund investment is having an actively managed portfolio. This can be critical for beginner investors who are just learning to monitor the market and adjust their holdings accordingly. A professional account manager typically takes care of monitoring, buying, and selling the stocks and bonds that comprise their specific mutual fund.
Unfortunately, this service leads us directly into one of the largest disadvantages of how mutual funds work: mutual fund fees.
Mutual Fund Fees
In a thorough mutual funds definition, it is inevitable to discuss mutual fund fees eventually. This can be a complicated subject to broach because mutual fund fees are calculated in a variety of ways depending on how you intend to make your mutual fund investment. Different funds, even good mutual funds, will all have different fee structures set up to cover the costs of actively managing the holdings.
We’ll give you a brief overview of the different types of fees you may encounter here in our mutual fund investment guide:
- Front-end loads: A front-end load is a fee that will be paid upfront when you make your initial investment. Ultimately, this lowers the amount of money that you are initially putting forward into shares of this specific mutual fund. Typically calculated as a specific percentage of your initial investment, you may also be able to negotiate discounts for agreeing to keep your shares for a specific period of time.
- Back-end loads: A back-end load is a slightly more complicated aspect of how mutual funds work. You will be able to invest all of your initial investment money into shares but will pay a percentage back when you sell your shares. Many times, there is a decrease seen in this percentage as you hold the shares for a longer period of time.
- Operating costs: One of the largest ways mutual fund fees are calculated is in operating costs. These fees can cover items that run the gamut from management fees to reinvestment fees to administrative fees. This is an important piece to how mutual funds work to allow the management service to continue to cover their costs and function at their best.
When you are investigating mutual fund fees, you should also take a look at their expense ratio, which is typically located in their prospectus. This generally represents the amount of money that is spent to maintain and continue to grow the mutual fund over time.
Most actively managed funds will come with an expense ratio of approximately 1% but you could see rates as high as 3% on some funds. This will take a serious cut of your earnings and profits over a long period of time. While an expense ratio isn’t always the deciding factor when it comes to buying mutual funds, it is certainly something to be considered.
Types of Mutual Funds
Not all mutual funds are created equal, just as not all stocks will be the perfect addition to your investment portfolio. Understanding the types of mutual funds is just as imperative as having a clear expectation for the mutual funds definition. We’ll cover two of the most popular and well-known types of mutual funds in this section: growth funds and value funds.
Keep in mind that there are many different variations on the types of mutual funds available. The mutual funds definition for the different types is rather broad, and it can encompass different holdings across asset classes, market sectors, and more. As you do more research on the areas of the market where you would like to see your money invested, you’ll begin to gain a better idea of which specific mutual fund investment you want to make.
Growth mutual funds are good mutual funds to buy for investors who are planning to hold their stocks for the long-term without seeing regular income. Investors and portfolio managers are keeping an eye out for companies that are anticipated to grow faster than those in the same category. They can include stocks from major companies or smaller and less recognized companies, based on the specific mutual fund investment strategy.
A good growth mutual funds definition would need to mention that they do not typically pay out in dividends or interest. Money is made from a growth fund when you decide to sell your shares and the price has appreciated since the time of your initial investment.
Value funds are easily understood as mutual funds where investors aim to buy stocks that are considered a bargain. Compared to the company earnings or earning potential, the individual shares are selling for a low price. Each management firm may have its own qualifiers for how mutual funds work and what constitutes a “bargain.”
These typically yield dividends or interest, which make them ideal for investors who want to earn income from their portfolios now. This is why you may also hear them referred to as income funds. According to one source, retired individuals are the most common investors in these types of mutual funds.
Identifying the difference between these two types of funds is typically a breeze. Once you know how mutual funds work, you’ll find that many options have the terms “growth” or “value” somewhere in their name. Decide which type of mutual fund investment works best for your investment needs and then find funds that meet the description.
Selecting Good Mutual Funds
When it comes to buying mutual funds, you want to make sure that you’re purchasing the very best ones to round out your investment strategy. There are several methods to ensure a good fit with your investments, but the first and most popular one would be to look at the ratings that the fund receives.
Independent companies such as Morningstar are known for providing ratings on a scale of one to five stars. They have an intimate knowledge of how mutual funds work and rank it according to performance, expense ratios, and other pertinent details to help balance return and risk. A higher rating from Morningstar indicates a better chance of future success.
In fact, in a study, they found that 75% of balanced one-star-rated mutual funds were no longer viable five years after their initial rating. For consumers who are interested in keeping their investments for the long haul, a low rating does not bode well for future investment potential.
Image Source: Morningstar
Bear in mind that many experts would recommend investing in mutual funds that differ from one another. Just as you would not put all of your investment money into one specific stock, you can purchase shares in multiple mutual funds. Buying mutual funds in this manner allows you to spread the risk out even further and diversify your holdings as much as possible.
If you choose to look at the mutual funds definition and try several different types of mutual funds, you want to make sure that you have some kind of strategy behind it. There are many popular philosophies and recommendations for how to go about diversifying your mutual fund holdings, but much of it boils down to your own preferences.
Apart from understanding the mutual funds definition and how mutual funds work, the most important thing you can do is to evaluate what your personal investment strategy is. Just because you know how mutual funds work and that a particular fund is highly rated doesn’t mean it will be a great addition for your investments. Ask yourself some of the following questions when considering a mutual fund investment:
- Do you plan to keep your mutual fund investment for a long period of time or are you interested in generating cash relatively quickly and moving on?
- What segments of the market are you most interested in making your investments in (healthcare, technology, etc.)?
- Do you have a preference for the types of securities held in your mutual fund investment (foreign, domestic, bonds, etc.)?
You will also need to take a close look at the prospectus and general information before investing in mutual funds. One key factor to keep an eye out for, apart from expense ratios, is the risk tolerance. Are you willing to tolerate a mutual fund investment that contains a great deal of risk, or do you prefer something less volatile?
An aggressive mutual funds definition would mean that you need to tolerate a much greater degree of risk. On the other hand, you could look into a more conservative mutual fund to assume less risk with your overall investment. Moderate mutual funds will fall directly in the middle of these two categories.
Conclusion: Making a Wise Mutual Fund Investment
When it comes to making a mutual fund investment, beginners can easily be overwhelmed by the sheer volume of data necessary to select a specific fund. By taking the time upfront to read through our mutual fund investment guide, you’ll be in a better position to understand the intricacies of your investment.
Knowing the correct mutual funds definition and how mutual funds work can allow you to begin planning a tailored investment strategy that suits your needs. Buying mutual funds can be as unique and personal as any other type of investment strategy. You simply have to decide which of the types of mutual funds will suit your needs and ideas the best.
With all of this information right at your fingertips, finding good mutual funds should be a walk in the park. After all, there are plenty of top funds to choose from that keep low mutual fund fees for a great initial mutual fund investment, even for beginners. Take advantage of having a professionally managed collection of holdings by making your first mutual fund investment.
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