How to Get Started with Mutual Fund Investing

FireAlarmMutual fund investing requires the least amount of effort and knowledge when it comes to investing.  With single stock investing you need to research stocks, learn how to put in different types of orders, track price movements periodically to find stocks that have gone south or that have grown too much, and spend time on taxes each year entering your capital gains.  With mutual funds, you just need to spend an hour or two once finding funds that meet your needs, then send in a check periodically.  The goal of this post is to give most of the information you need to know to start investing in mutual funds.


What are stock and bonds?

Stocks are ownership stakes in corporations.  You actually are buying a part of the company in which you’re investing.  If the company does well and starts making more money, the value of your part of the company normally increases.  Once a company gets large enough that they don’t need all of their income for expansion and growth, often they will start giving you a portion of the profits they make in what is called a dividend.

A bond is a loan to a company (or a city, federal government, etc…).  In exchange, they agree to pay you interest for a certain period of time, and then give you your money back at the end.  (This is assuming that you bought the bond directly from the company.  If you bought the bond from someone else, you get paid whatever the first person who bought the bond paid the company.  This is called the par value and is normally $1,000 per bond for corporate bonds.)  The price of a bond will depend on interest rates at the time, how long it is until the loan is to be repaid, and how likely people think the company is to repay the loan.

What are mutual funds?

Mutual funds are collections of stocks, bonds, or other investments.  When you buy into a mutual fund, you are giving money to a manager who then invests the money for you.  Your money is pooled with that of many other people, such that you can own a small amount of a lot of different companies and investments.  This would be impossible investing on your own outside of a fund since it would cost way too much to buy that many different stocks unless you had a lot of money to invest (several million dollars).  The main reason for buying mutual funds is to get diversification, which is where you spread your money out to several different investments.  This reduces your risk of taking a large loss due to a significant event at a single company since each company only makes up a small amount of the fund and there are other companies that will generally do well during the same period.  Think of it this way – if you buy one home without insurance, you run the risk of a fire causing you to lose your whole investment.  If you buy homes all over the country, one fire would only cause a small percentage loss.

What are the risks of buying mutual funds?

Mutual funds are not like a bank account.  There is no guarantee that you will get a specific return on your investment or even get all of your money back.  They are safer than individual stocks and bonds, but there is still investment risk.  Another risk is not that the fund will actually lose value, but that it will not go anywhere for a significant period of time, meaning you would have done better putting your money into a bank CD.

If they’re so risky, why buy them?

If you include inflation, your savings in a bank account will actually decrease with time.  A dollar fifty years ago would buy what $100 does now. Because the value of companies increases (in dollar terms) with inflation, you really need to invest money that you will not be using in the next few years.

Beyond inflation, because companies are growing and expanding, their stock will become more valuable over time.  If you buy a whole set of stocks (as with a mutual fund), some companies may fail or go nowhere, but the ones that do well will make up for the others and then some.  While there are no guarantees, over most long periods of time, like 10-20 years, stocks have returned between about 10 and 20% per year.  This is way better than bank returns.  So long as nothing happens to cause the entire economy to collapse, mutual funds should offer much better returns than bank accounts in the future.  This gives the average worker a way to retire with a great deal of money without actually saving up all of the money.

How do I buy mutual funds?

The easiest way to buy funds is to go to the website for one of the fund companies (Vanguard, Fidelity, Janus, etc…), start an account, and then send in a check or transfer funds electronically from your bank account.  Probably my favorite family of funds is Vanguard, but there are many others.  Most funds have minimum investments, between $3,000 and $5,000.  Some companies allow smaller amounts to start if it is for a retirement account and/or you allow automated future investments from your account.  Note that because the fund companies will probably lose money on your account when you have little invested since their costs to send statements and handle your transactions will be more than they’ll be charging you in fees, they will want you to grow your investments as quickly as possible.

How do I select which funds to buy?

The company should have the funds available on their investing website.  Each of the funds will have a document called a prospectus that tells about the fund.  The most important things to you will be their investment objectives and their fees.

You can tell generally what the investment objectives are from their name normally, but an objective statement should be the first thing in the prospectus.  Read this statement to understand what the fund does.  What sort of things do they invest in?  Are they a managed fund, where a manager picks the investments, or are they an index fund that tries to match the returns of a specific index?  Do they buy stocks, bonds, or a mixture?

You’ll want to have a mixture of funds that invest in different areas of the markets.  A large-cap fund such as an S&P500 fund is a good first fund, as is a small Cap Fund such as the Nasdaq QQQ fund.  You can also just buy a total stock market fund that basically invests in everything.   If you will need the money in the next  ten to fifteen years, or if you just want to the value of your portfolio to be a bit less volatile, you can add a bond fund to the mix.  A rule-of-thumb if you’re investing for retirement is to “invest your age minus ten percent” in bonds, meaning if you’re 50, you’ll be 40% in bonds and 60% in stocks.  In general, the larger the percentage of bonds you have, the less volatile your portfolio will be, but the lower your return will be over long periods of time.  In down markets, bonds tend to not decline as much as stocks.  In up markets, however, they won’t go up as much either.

Rather than dumping all of your money in at once, it is a good idea to buy regularly over time.  If you invest fixed amounts regularly you’ll get a better price since you’ll buy more shares when the funds dip and price and less when they rise.  This is easy if you’re saving up and investing as you go.  Just add more money each time you save up a five hundred to a thousand dollars or so.  If you have a lot to start with, invest it over a year or two, perhaps buying more each time the market dips, but still buying even when the market is rising since there can be some runs that go for a long time.

On the fees, the prospectus will generally give the fees and expenses as a percentage of investment value, plus a table showing how much in fees would be paid over a 5 or 10 year period if you owned the fund.  You generally want fees to be less than 1% of assets.  0.25% of assets or lower is very good.  Unmanaged funds such as index funds generally have the lowest fees since they don’t have a team of managers to pay, a research department, and so on.  When choosing which fund to buy, choosing the one with the lowest fees is usually the best option.  In general, ignore their past returns.  Buying a fund that has done really well in the past may mean that you’re just buying in at the top.

What do I need to do to maintain the portfolio?

In general, there is nothing you need to do after you buy in.  If you’re investing regular amounts, just keep buying as you raise money, purchasing whatever is needed to keep your funds in balance based upon your chosen allocations.  For example, if you want to have 80% stocks and 20% bonds and bonds have risen such that you’re 30% in bonds, direct new money towards stocks.  If things get really out-of-whack you can move money between funds, but you’ll need to pay taxes on any gains for the shares that you sell unless the portfolio is in a tax-sheltered account such as an IRA or a 401K.

Speaking of taxes

If you’re investing in a tax-sheltered account, there are no tax concerns until you start taking the money out.  If you’re in a taxable account, you’ll need to keep track of gains and losses when you sell shares and add them to your income tax forms.  It is best to see an accountant for this since a good accountant will also give you tips on how to minimize taxes, although I’m sure tax software can probably handle most things.  In general, you’ll not want to sell very often in a taxed account, although realize that a small move int he markets can quickly wipe out any tax savings, so don’t let fear of taxes drive youinvestinggn decisions.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


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