Mutual Funds

Background

Mutual funds are shared investments. That means they use money from multiple people to invest in a mixed group of stocks, bonds, or other securities (more on securities here). 

Although mutual funds provide an easy way for people to diversify their portfolios, these investors won’t actually own shares of any of the companies the fund invests in. Instead, they’ll own shares of the mutual fund, which invests in the companies for them. The result is a less risky investment overall—but also a somewhat lowered rate of returns.

How They Work

Investors can purchase shares of a mutual fund through a brokerage firm—but the most common way people invest is through their 401(k) plans. Most mutual funds have a minimum investment (which can range from $500 to thousands of dollars), but some offer no minimums. 

These funds also come with fees. Those can include a transaction fee and management fee, among others. The fees can range dramatically depending on the type of fund and class you invest in (learn more about mutual fund classes here). 

Mutual funds are commonly managed by portfolio managers who actively buy and sell shares. With an “actively managed” fund, investors benefit from managers who are trying to outperform the fund’s benchmark when trading shares (a way to measure the fund’s performance). However, actively managed funds can be more expensive than others. 

To calculate a mutual fund’s price, or its net asset value, take the overall value of the collected securities and divide that by the total number of unsold shares. The price shifts on a daily basis, depending on each stock’s value at the end of the day. 

Types of Mutual Funds

The four main categories of mutual funds are stock funds, bond funds, money market funds, and target-date funds. While they all follow the same tenets of what makes up a mutual fund, they have different NAVs, guidelines, and returns (find the right type for you with this tool).

The biggest difference between these four types of funds is the type of securities that they invest in.

Stock funds invest in the stock market. There is a lot of variety found in stock funds—some focus on a regular dividend payment (called an income fund) and others focus on a certain market index (called an index fund). Some will even specialize in specific industries, like tech (called a sector fund). Ultimately, the type of stock fund an investor chooses depends on their personal goals. 

Bond funds invest in bonds, which are fixed-income investments that pay periodic interest.

Money market funds invest in low-risk securities, most commonly Treasury bills. They act as a short-term investment option and tend to have relatively low returns. 

Target-date funds (or life cycle funds) invest in a mix of stocks, bonds, and other securities. This type of mutual fund is ideal for investors looking to focus on long-term investing goals, like retirement, since they’re lower risk. 

Pros and Cons 

Risk-averse investors who don’t want to manage their own portfolios and like the idea of getting higher returns than a savings account or CD could provide might gravitate toward mutual funds. 

While mutual fund investors reduce the risk of losing money if a company the mutual fund invests in goes under, they also limit potential rewards if a company performs well. Plus, mutual funds come with a list of fees. Although these vary per fund and brokerage firm, investors will have to do more research up front to find low-fee funds.