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What Are Mutual Funds?

If the mere mention of the phrase mutual funds has your eyes glazing over with confusion, trust us—you’re not alone. We’ve all been there. The good news is, they’re not as complicated as you may think. 

Simply put, mutual funds are professionally managed investment portfolios that allow investors to pool their money together to invest in something.

With the help of an investment professional, mutual funds are a great way to invest for your retirement. But you should never invest in something you don’t understand. So let’s take a closer look at what mutual funds are, how they work, and why they can become the most valuable tool in your retirement investing strategy.

Mutual funds are professionally managed investment portfolios that allow investors to pool their money together to invest in something.

How Does a Mutual Fund Work?

It may help to think of it like this. Imagine a group of people standing around an empty bowl. They each take out a $100 bill and place it in the bowl. These people just mutually funded that bowl. It’s a mutual fund. Makes sense, right?

money bag

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Now, what the money is used to invest in will tell you what kind of fund it is. If I go out and use the money to buy stock in international companies, then the fund would be an international stock mutual fund. What if I decided to buy bonds? Then it would be a bond mutual fund. See? Not that complicated!

Inside a typical growth stock mutual fund are stocks from dozens, sometimes hundreds, of different companies—so when you put money in a mutual fund, you’re basically buying bits and pieces of all those companies. Some of those company stocks may go up while others go down, but the overall value of the fund should go up over time. And as the value of the overall fund goes up, so do your returns!

One of the great things about mutual funds is that you don’t have to have a lot of money to get started, and—thanks to their diversity of investments—you can invest confidently because all of your retirement eggs aren’t in one basket.

Types of Mutual Funds

Let’s take a closer look at the different types of mutual funds. Today, more than $23.9 trillion of assets like stocks, bonds, cash and money market accounts are held in almost 8,000 mutual funds—and that’s just in the U.S. alone!1 

Each of those funds has its own specific investing strategy, and each comes with its own risks and rewards. With so many mutual funds to choose from, trying to pick the right ones might feel overwhelming—kind of like trying to pick a meal from a massive menu.

Here are a few of the main types of mutual funds you need to know about:

Stock Mutual Funds

Stock mutual funds are invested in stocks from dozens or potentially hundreds of different companies. But the kind of company stocks that are inside a stock mutual fund depends on what the fund’s goals and objectives are. Here are some different types of stock mutual funds you might come across.  

Growth Funds

These funds invest in companies that have potential for growth in the future. Usually, you won’t get a regular dividend payment from these types of funds, but you’ll make money when you sell your shares of the fund in the future.

These types of funds are perfect for long-term investing! We’re going to talk more about these a little later.

Index Funds

Index funds are designed to mirror the performance of a particular market index by investing in the companies that are in that index. So if you look inside the S&P 500 Index Fund, which is designed to track the progress of the stock market as a whole, you’ll find that the fund only contains stocks from companies that are part of the S&P 500 index. 

Income Funds

Income funds are interested in stocks that pay regular dividends. An investor who wants an income fund probably isn’t worried about how much a stock’s price rises or falls. They’re more concerned with consistently getting a small cut of the earnings from the companies inside that fund throughout the year. 

Sector Funds

Sector funds focus on investing in company stock within a certain industry or sector of the economy. If you’re investing in a technology sector fund, for example, you would look inside that fund’s portfolio and find that the fund is filled with stocks from all kinds of tech companies . . . but only tech companies.

Bond Mutual Funds

When you buy a bond, you’re basically lending money to a company or government and, in return, you get a steady stream of income (in the form of dividend and interest payments made to you). So a bond mutual fund is when a group of investors pools their money together to purchase a bunch of different bonds.

While bonds (and bond mutual funds) are seen as a “safer” investment with lower risks than stocks, you’re going to have to settle for unimpressive returns that barely outpace inflation . . . and why would you want that?

Hybrid Mutual Funds

Hybrid funds invest in a mix of stocks and bonds. This approach tries to balance the potential growth of stocks with the income and stability of bonds over the long haul.

There are really two main types of hybrid mutual funds: balanced funds and target-date funds. Balanced funds have a mix of stocks and bonds that stays the same. Target-date funds shift from more aggressive to more conservative over time with a goal of building a big nest egg first and then protecting it as you get closer to retirement.

Money Market Funds

Money market funds (not to be confused with money market accounts) are mutual funds invested in something called “short-term debt securities.” What in the world is a short-term debt security? It’s basically money loaned to a government, company or bank for a very short period of time. The money borrowed, plus interest, is usually due back to investors in less than a year.

Like a bond mutual fund, money market funds are supposed to give investors a steady stream of income through regular interest payments . . . but they also won’t make you much money in the long run either.

What Mutual Funds Should I Invest In?

Now, there are many different types of funds out there, but we recommend investing evenly across four different types of growth stock mutual funds: growth and income, growth, aggressive growth, and international funds. Let’s take a closer look at each.

1. Growth and Income

Growth and income funds, sometimes called large cap funds, are mostly made up of stocks from big companies—including some you’ll probably recognize, like Apple or Microsoft—that are valued over $10 billion. They’re more predictable and the calmest type of funds available. Although their returns aren’t always as high as other funds, they’re what many consider to be a low-risk, stable foundation for your portfolio.

2. Growth

Growth funds are just what they sound like: They’re funds invested in medium to large companies that still have room to grow. You’ll sometimes see these funds listed as mid cap funds. Even though they have a knack for rising and falling with the economy, growth funds are pretty stable overall and usually earn higher returns than growth and income funds.

3. Aggressive Growth

Aggressive growth funds—sometimes called small cap funds—are the "wild child" of mutual funds. When they’re up, they are really up, but when they’re down—watch out! Made up of stocks from companies with a lot of potential for growth (like small tech start-ups or large companies in emerging markets), they’re your chance to take a big risk for a potentially bigger financial reward.

4. International

Did you know plenty of American household names are not American at all? Gerber, Trader Joe’s, Frigidaire appliances and Holiday Inn are all foreign-owned businesses. By including international funds in your mutual fund portfolio, you can benefit from the success of well-known companies overseas.

How Do I Buy a Mutual Fund?

There are a few different ways to invest in mutual funds. If it’s an option for you, the best place to start is the retirement plan offered at your work, like a 401(k). Why? Because it comes with plenty of benefits like:

  • Tax-deferred growth of your investments—or tax-free growth if you have a Roth 401(k)
  • An employer match to your contributions that instantly doubles the amount of money put into your 401(k) every paycheck
  • Automatic contributions from your paycheck

When you’re looking over the mutual fund options included in your workplace plan, work with your financial advisor to select the best ones. Once you’ve made your selections, invest as much as it takes to receive the full employer match.

If you don’t have a workplace retirement plan, or you’ve maxed out your employer’s match, you can invest in mutual funds through a Roth IRA with the help of an experienced investment professional.

Your goal is to invest 15% of your income for retirement. That’s a big goal that you’ll need to stay focused on long term, so keep working with your investing pro to make sure you stay on track.

What Costs Come With a Mutual Fund?

Nothing is ever really free—and mutual funds are no exception. Mutual funds pass along their costs to investors through all sorts of investment fees and other expenses—things like shareholder fees, operating expenses, front-end load fees, purchase fees, back-end load fees, redemption fees, exchange fees and account fees.2

Fees are a fact of life when it comes to investing, so your goal is to choose mutual funds that perform well and have reasonable fees. This is exactly why you need a pro in your corner.

A good investment professional can help you understand the costs that come with investing and how they will affect your end result. They’ll not only work with you to understand your financial goals, they’ll also help you understand those "hidden" fees so you can avoid surprises that could eat away at your nest egg!

How to Choose the Right Mix of Mutual Funds

Listen, there will always be some level of risk involved when you’re investing. That’s just part of the deal. But there are a few ways you can reduce the risk of investing so you can sleep a little easier at night.

1. Look at the fund’s long-term history.

When deciding on a mutual fund, it’s important to look at its history and how it’s performed over the last 10 to 20 years—not just the last year or two. It can be tempting to get tunnel vision and focus only on funds that brought stellar returns in recent years. Instead, take a deep breath, step back, and look at the big picture.

2. Compare similar mutual funds.

You’ll also want to understand how the mutual fund has performed compared to other similar funds in the market over long periods of time. Is it at least keeping up with a good benchmark like the S&P 500, or has it been performing so badly that it’s making even the "worst" funds look good? All in all, to lower your risk, you want to choose a fund that has a long-running track record of strong returns.

3. Diversify, diversify, diversify.

Whenever you hear the word diversification, that just means you’re spreading your money around. Mutual funds, which are filled with stocks from many different companies, already have a certain level of diversification built into them.

And when you add another level of diversification by spreading your investments across those four different mutual fund types mentioned earlier, you lower your risk even more.

Even when you diversify, it’s not always going to be sunshine and rainbows when it comes to investing for retirement. There are going to be some good days, and there are going to be some bad days. But choosing a good mix will help you build a weatherproof retirement that will help you get through those rainy days.

Mutual Funds vs. ETFs: What’s the Difference?

Just like their name suggests, exchange-traded funds—or ETFs—are basically funds that are traded on an exchange. They are similar to mutual funds in lots of ways:

  • They pool money together from many investors to purchase investments for the fund.
  • They’re both managed by a group of financial professionals.
  • They come in a variety of different flavors (there are stock ETFs, bond ETFs and even ETFs that have a mix of both).

But there are some important differences between mutual funds and ETFs—the most obvious one being how they are bought and sold. You see, mutual funds can only be bought and sold at the end of the day after the market closes. That’s because the price of a mutual fund is set once a day. You can also set up automatic payments to buy more shares each month, which is a nice feature for long-term investors.    

That’s not the case with ETFs, which are designed to be traded like stocks. That means the price of an ETF goes up and down throughout the day, and investors can buy or sell them in response to these short-term swings. Because of that, you don’t have the option to set up an automatic payment to buy shares of ETFs like you could with a mutual fund.

What Are the Main Benefits of Mutual Funds?

We’ve covered a lot of ground on mutual funds, but here are three reasons why mutual funds are the perfect investments to help you save for retirement and build wealth for the long haul:

1. Instant Diversification

You know the old saying “Don’t put all your eggs in one basket”? That’s diversification in a nutshell—it just means you are spreading your investments across many different companies so that you reduce your risk.

Mutual funds, which can have stocks from hundreds of different companies, make it easy for investors like you to diversify your portfolio because they have diversification built into them.

2. Lower Costs

Trading single stocks can get expensive because you might end up paying transaction fees for every single stock you buy and sell. Those fees can add up really fast!

Mutual funds, on the other hand, make it affordable to invest in a wide range of stocks without those pesky transaction fees.   

3. Active Management

Index funds and most ETFs have a “set it and forget it” approach to investing. Like that lazy classmate you had in high school, they’re happy to just copy what a stock market index like the S&P 500 is doing and call it a day.

Mutual funds, on the other hand, are often run by a team of investment experts who want to beat the stock market’s returns. They set the fund’s strategy, they do their research, and stay on top of the fund's performance and make adjustments if they need to.

Work With a Financial Advisor

You don’t have to camp out on the trading floor of the New York Stock Exchange to get smarter about your retirement. Mutual funds are a straightforward, affordable way to begin investing for the long haul.

No matter what is happening with the stock market, our advice is the same: Invest in the right mix of mutual funds with a history of strong performance, and stick with them over time.

No matter what is happening with the stock market, our advice is the same: Invest in the right mix of mutual funds with a history of strong performance, and stick with them over time.

If you’re ready to take control of your financial future, then it’s time to sit down with a SmartVestor Pro. You can work with a financial advisor as you select your funds, devise a long-term investing strategy, and stick with that strategy whether the stock market is swinging up or down. Your pro will help make sense of your investing options and walk you through the process so you can set real goals.

Find your SmartVestor Pro today!

These are general guidelines. Your situation may be unique. If you have questions, connect with a SmartVestor Pro.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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