There’s a lot to love about mutual funds! But maybe after doing some research on your own, you’re a little overwhelmed by all the details and feeling lost in the lingo. Front-loaded, end-loaded, over-loaded . . . it’s easy to get confused!
First, take a deep breath! Once you get past all that fancy investment jargon, you’ll see that mutual funds really aren’t all that complicated and are a big player in helping you build wealth for retirement.
We’re going to help you cut through all the noise so you can leave here knowing exactly what a mutual fund is and how to invest in them the right way. Ready? Let’s do this!
What Are Mutual Funds?
First things first, let’s define what a mutual fund actually is. Simply put, a mutual fund is created when a group of investors pools their money together to invest in something.
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Mutual funds are managed by a team of investment professionals, and this team selects a mix of investments to include in the mutual fund based on the fund’s objective. If the fund is used to buy growth stocks, for example, then it would be called a “growth stock mutual fund.” See? That’s not too hard to understand!
The great thing about mutual funds is they give investors like you a chance to invest in many different companies all at once, which is much less risky than hitching your bets on single stocks (bad idea!). If you have a tax-advantaged retirement savings account, like a workplace 401(k) plan or a Roth IRA, that’s the best place to start investing in mutual funds.
How Do You Make Money From Mutual Funds?
When mutual funds increase in value, the profit is shared with the investors. Those profits are either paid out to investors, usually in annual payments called dividends, or they can be reinvested to buy more shares of the fund. Those shares make more profit, which can be reinvested and on and on. Everybody wins!
We should mention that if you’re investing in mutual funds inside a retirement account, your dividends are automatically reinvested. That’s why you won’t see any dividend checks from your 401(k) or IRA at the end of the year. But you will own more shares of a profitable mutual fund. Pretty sweet deal, right?
We want you to hear us loud and clear—the most important factor in making money from mutual funds is first, that you actually invest in mutual funds—you don’t just talk about it. And second, that you invest consistently for a long period of time. That’s right, simply investing and continuing to invest is even more important than what funds you choose to invest in!
Will there be ups and downs investing in the stock market? Of course! But historically, most people make money in the long run if they’re patient. Just look at the S&P 500, for example. The S&P 500 tracks the performance of stocks from the 500 largest, most stable companies in the U.S., and it has an average annual return between 11–12% from 1928 to 2020.1
That’s why you want to use a buy-and-hold strategy when investing in mutual funds. Don’t try to time the market by buying and selling based on trends. Choose investments with a long history of above-average returns and stick with them for the long haul. Remember, saving for retirement is a marathon—not a sprint!
The bottom line: Stop listening to the broke investment theory blogger who lives in his parents’ basement and just freaking invest!
How Should I Invest in Mutual Funds?
Now it’s time to get down to business! If you’re ready to start investing in mutual funds, just follow these simple steps and you’ll be well on your way:
1. Invest 15% of your income.
Wealth building takes hard work and discipline. If you want to invest for your future, you need to plan on investing consistently—no matter what the market is doing.
After you’ve paid off all debt (except for your house) and built a solid emergency fund, invest 15% of your gross income every month for retirement. Once you get in the habit of investing consistently, you’ll realize you don’t even miss that money!
Why 15%? Why not more or less? Because we’ve seen millions of Americans become Baby Steps Millionaires by saving 15% consistently over time while still having enough room to save for other important financial goals—like saving for their kids’ college and paying off their house early. If they could do it, so can you!
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2. Invest with tax-advantaged retirement accounts.
There are no shortcuts to building wealth, but there are strategies that can help your money go further. For example, investing in mutual funds in tax-advantaged accounts through your workplace, like a 401(k), is a great way to get started. And if you get a company match on your contributions, even better. That’s free money and an instant 100% return on your investment, people!
But don’t count the match as part of your 15% goal. It’s nice to have, but it’s just the icing on the cake of your own contributions.
If you have a traditional 401(k) at work with a match, invest up to the match. Then, you can open a Roth IRA. With a Roth IRA, the money you invest in mutual funds goes further because you use after-tax dollars—which means you won’t have to pay taxes on that money when you withdraw it in retirement. It’s all yours!
The only downside to a Roth IRA is that it has lower contribution limits than a 401(k).2 It’s possible to max out your Roth IRA without reaching your 15% goal. That’s okay! Just go back to your 401(k) and invest the rest of your 15% there.
Have a Roth 401(k) with good mutual fund options? Even better! You can simply invest your whole 15% in that account and boom—you’re done!
Here’s the thing about your Roth options: They’re huge for your retirement savings, so do all the Roth you can. When you’re ready to retire, the majority of the money in your retirement account will be growth. Not having to pay taxes on that money means you keep hundreds of thousands of dollars in your pocket. If you ever get confused about which account is best, just remember: Match beats Roth beats Traditional.
3. Diversify your investment portfolio.
Whenever someone talks to you about investing, the word diversification probably gets thrown around a lot. All diversification means is you’re spreading your money out across different kinds of investments, which reduces your overall risk if a particular market goes south.
That’s a good thing! After all, the last thing you want to do is treat your retirement portfolio like the Kentucky Derby and bet it all on one horse.
That’s why you should spread your investments equally across four types of mutual funds: growth and income, growth, aggressive growth, and international. That keeps your portfolio balanced and helps you minimize your risks against the stock market’s ups and downs.
Below are the four mutual fund categories we talk about and the reasons why we recommend them:
- Growth and income: These funds create a stable foundation for your portfolio. These can be described as large, well-known (big and boring) American companies that have been around for a long time and offer goods and services people use regardless of the economy.
- Growth: This category features medium or large U.S. companies that are experiencing growth. Unlike growth and income funds, these are more likely to ebb and flow with the economy. For instance, you might find the company that makes the latest "it" gadget or luxury item in your growth fund mix.
- Aggressive growth: Think of this category as the wild child of your portfolio. When these funds are up, they’re up. And when they’re down, they’re down. Aggressive growth funds usually invest in smaller companies with lots of “potential.”
- International: International funds are great because they spread your risk beyond U.S. soil and invest in big non-U.S. companies you know and love like Toyota, Samsung and Nestlé. You may see these referred to as foreign or overseas funds. Just don’t get them confused with world or global funds, which group U.S. and foreign stocks together.
4. Don’t chase returns.
It can be tempting to get tunnel vision and focus only on funds or sectors that brought stellar returns in recent years. Just remember, nobody can time the market or predict the future (unless you happen to have a time-traveling DeLorean parked in your driveway).
Before committing to a fund, take a step back and consider the big picture. How has it performed over the past five years? What about the past 10 or 20 years? Choose mutual funds that stand the test of time and continue to deliver strong returns over the long haul.
5. Brush up on investing lingo.
Listen, you don’t have to be an expert in investing lingo to choose the right mutual funds. But a basic understanding of some of the most common terms will help. Here’s a little cheat sheet to get you started:
- Asset Allocation: The practice of spreading your investments out (diversifying) among different types of investments with the goal of minimizing investment risk while making the most of investment growth.
- Cost: Make sure you understand the fee structure that your financial advisor uses to get paid. Also, pay attention to the fund’s expense ratio. A ratio higher than 1% is considered expensive.
- Large-, Medium- and Small-Cap: Cap stands for capitalization, which means money. To most investors though, it refers to the size and value of a company. Large-cap companies carry lower risk, but you’ll make less money. Medium-cap companies are moderately risky, and small-cap companies are the riskiest—but have the biggest payoffs.
- Performance (Rate of Return): Again, you want a history of strong returns for any fund you choose to invest in. Focus on long-term returns—10 years or longer if possible. You’re not looking for a specific rate of return, but you do want a fund that consistently outperforms most funds in its category.
- Portfolio: This is simply what your investments look like when you put them all together.
- Sectors: Sectors refer to the types of businesses the fund invests in, such as financial services or health care. A balanced distribution among sectors means the fund is well diversified.
- Turnover Ratio: Turnover refers to how often investments are bought and sold within the fund. A low turnover ratio of 10% or less shows the management team has confidence in its investments and isn’t trying to time the market for a bigger return.
Getting familiar with these terms will help you feel a little more comfortable as you make investing decisions with your investment professional.
6. Work with a financial advisor.
There’s a reason why most millionaires we talked to for the The National Study of Millionaires said they worked with a financial advisor to achieve their net worth.
A good investment professional can do two very important things. First, they can help you pick and choose what mutual funds to include in your retirement portfolio. Be clear about your goals up front so that you and your pro are on the same page before you make any decisions!
And second, they can help you sort through all the lingo and jargon of the investing world. If we've said it once, we've said it a hundred times: Never invest in anything you don’t understand. No one cares about your future as much as you do, so it’s your job to take charge of your own mutual fund education.
If this sounds like a lot of information to dig through and compare, you’re right! The good news is you don’t have to do it all alone. You can work with a SmartVestor Pro who understands your goals and can help you make investment choices for your future.