What You Need To Know Before You Invest In Mutual Funds

| January 3, 2020

mutual fundsWhen I was struggling to pay off my debt, all I wanted was enough money to pay my bills. Even though I worked in a financial firm out of college, I was not in a position to think about the future or investing for myself. However, no matter where you are on your debt journey, I want to share with you some insights about how to start investing, and I want to focus here on how you can invest in mutual funds.

Whether you decide to invest in them is totally up to you and what is best for your situation. But, I think it is important to understand the basics of investing because it will be a way for you to generate a passive income for yourself and your family.

What are mutual funds?

Have you ever heard of friends coming together and creating an investment group to purchase stocks or bonds together? Think of mutual funds that way. They are a group of people pooling their money together to buy stocks, bonds and maybe short-term debt. However, this is a professional operation and not just a bunch of friends.

I was surprised to learn that forerunner of today’s mutual funds go back to the 1700s. It seems the reason then is the same as today: Diversify your risk so you can safely make a nice return on your investments.

There are different kinds of mutual funds:

  • Stock funds: Most of the time when people talk about mutual funds they are referring to stock funds. These are where the managers of the funds purchase corporate stocks. There are a number of different kinds of stock funds: Growth funds invest in stocks that have a potential for higher financial returns; income funds invest in stocks that pay a good dividend; index funds purchase shares of all the companies in a particular market (like the S&P 500) so your returns will match closely to the broader market; and sector funds that focus on specific industries. The collection of investments is called the portfolio.
  • Target date funds: These funds contain a mix of stocks, bonds and other kinds of investments, like short-term debt notes. The goal of managers is to combine these different kinds of investments to match your expected retirement date. Generally, the thinking is the more time you have until retirement, the greater the risk you can take with your investments. As you get closer to retirement, the mix of investments will become a little more conservative, so you will end up owning a larger percentage of bonds.
  • Bond funds invest in a variety of bonds and other kinds of debt instruments. These include government, corporate, municipal and short-term notes. They can also include mortgage-backed securities.
  • Money market funds focus on short-term debt guaranteed by commercial banks, certificates of deposits, corporate debt, government securities, and U.S. Treasurys. Do not confuse them with money market accounts; they are totally different.

Why should I invest in mutual funds?

As you read this, please remember I cannot give you financial, legal or tax advice, but I want to help you navigate from debt to financial freedom, and investing in mutual funds can play a role. You should always consult a financial professional before investing. And, before you invest a single dollar you have to realize every investment involves risk. This is why financial advisors often say only invest money you can afford to lose.

Whenever you plan to invest, it’s always a good idea to understand how much risk you can handle. Some people like to play it safe and like a sure thing. Well, there really is no such thing as a sure thing when talking investments. But, there are safer alternatives like bond and money market funds. Some people want to be aggressive and try to make as much as possible. You will find these people investing heavily into growth funds.

But, the reason why you should consider investing in mutual funds is to get your money working for you instead of you working for your money. It is that simple. I briefly mentioned generating a passive income. At some point, you want to start earning money in ways that involve minimal effort on your part. Some people invest in rental properties, some people receive stock dividends, and others receive book royalties. When you invest and realize a return, you are earning a passive income. A good mutual fund can do that for you.

How do I invest in mutual funds?

Most people purchase their first mutual funds through their employers. Over the years, companies have shifted from offering their workers employer-backed pensions to offering them the opportunity to invest in a retirement account where they have access to several kinds of mutual funds. These funds involve varying levels of risk, and it might involve your employer matching the funds you invest.

You can open a mutual fund account through your employer’s benefits program, a local financial advisor, brokerage firms, an online investment firm, directly from the fund companies, or even through apps. Depending upon the route you go, you can expect to open your account with a modest amount or up to $3,000. If it is through an employer, it will be whatever amount or percentage of your paycheck you decide. If it is through an app, it might be as little as $5. If it is online, you can find some with a $100 minimum investment. Through a local advisor, it might be somewhere between $500 to $3,000, depending upon the fund.

When you figure out how much risk you want to take,  you can start narrowing your focus. Mutual funds are regulated by the Securities and Exchange Commission, and they are required to produce a prospectus, which you can request or download.

This prospectus is a detailed document that outlines several key factors of the mutual fund, including what is its investment strategy, what kind of risks it takes, how it has performed historically, and who is managing the fund. It is good to see how a fund has performed historically.

When you start looking at a mutual fund’s track record over the past year, five years or 10 years, understand no matter how good past performance is, that does not mean it will do as well moving forward. There are always risks.

What kind of fees can I expect to pay?

There is no such thing as a free lunch, so whenever you invest in a mutual fund, or anything else, there will be fees to pay. How much depends upon the fund. There are a lot of factors that make up fees. When you understand what those fees are, you will make better investment decisions.

In an Investor Bulletin outlining Mutual Fund Fees and Expenses, the SEC wrote this: “Even small differences in fees from one fund to another can add up to substantial differences in your investment returns over time.” What this means for your investment dollars is this: The higher the fees, the better your mutual fund choice needs to perform to cover those costs.

The SEC outlines to big categories: Shareholder fees and operating expenses. These will be spelled out in the prospectus. but include:

  • Management fees;
  • Costs associated with marketing and selling the fund (called 12b-1 fees);
  • Transaction fees when the fund buys or sells stocks;
  • Sales commissions, sometimes referred to as loads (front-end load means you pay up front and it reduces the initial investment amount, and back-end load means you pay when you sell your shares);
  • Other fees (like a redemption fee if you do not hold your shares long enough or an exchange fee if you move your money into a different fund with the same company)

When you read the prospectus, look for what is called the expense ratio. This figure will tell you what percentage of the mutual fund’s assets are spent to manage and operate it. If two funds produce similar returns, say 10 percent, but one has an expense ratio of 0.75% and the other has an expense ratio of 1.5%, which one do you think is the better choice? Let’s look at this from a different perspective: Would you rather pay 75 cents or $1.50 for a similar cup of coffee?

If you have a mutual fund through your employer’s retirement benefits plan, then you can get a free analysis of your both your allocation (what stocks and what percentages are in your mutual funds) and your fees through Blooom. The analysis is absolutely free. You will get a fresh set of eyes looking at your retirement account and making suggestions, which you can act upon or ignore.

If you decide to have Blooom make those changes, then you will pay a fee. What has resonated with a lot of people like you who have taken advantage of Blooom’s analysis is that it has revealed hidden fees they never knew they were paying.

What is the best mutual fund to invest in?

The best mutual fund to invest in is one that aligns with your values, which we really haven’t discussed. Whenever investing, sometimes people don’t care what stocks a mutual fund invests in; they just want the biggest bang for their buck. However, others want to make sure the stocks align with their environmental, societal or governance concerns. These are called ESG, or socially responsible funds. If these are passions of yours, then look for ESG funds that align with your values.

You will also want to choose funds that fit your risk level. If you like safer bets, then you will want funds with more bonds and money market investments. If you want to be aggressive, look for growth funds.

Also look for funds that complement your savings goals. Are you looking for a great retirement? Are you investing to help pay for a child’s college education? What kind of time frame do you have? This is where the personal touch can come in handy.

Because we are all unique, there is no one best mutual fund to invest in, but there are a lot of winners out there if you are willing to look.

When we are saddled with debt and scraping to find the extra cash to pay our bills, it is nearly impossible to focus on the future and a life beyond our financial obligations. However, if you are ever going to experience financial freedom, you need to start thinking about your future, one that will be much brighter and involve investing. Maybe you aren’t there today, but let’s start focusing on getting out of debt and then begin investing in a mutual fund or exchange-traded fund, whether it is through an employer or one of the services mentioned above.

Start planning for a better tomorrow today. All of us have to start somewhere. If you cannot do it today, then have a plan in place for when you are able. Remember, I was deep in debt and in an accident that sidelined me. I did it, and I have confidence that you can do it, too. I wish you all the best!

Note: This article originally appeared at The Budget Mom.

 

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Category: ETFs

About the Author ()

Hi there! I’m Kumiko, or just call me Miko. I was tired of living paycheck to paycheck and feeling hopeless. So I paid off $7,500 in credit card debt and became an Accredited Financial Counselor® I created The Budget Mom to share my knowledge and to keep me accountable as I strive to live a life I love on a budget that I can afford. Here you will find tips for saving more, spending less, and some ideas on how to make life a little bit easier.

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