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What Are Mutual Funds? And How Do They Work?

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. 

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.

What Is a Mutual Fund?

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

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

Mutual funds have a team of professionals working behind the scenes, picking and choosing which stocks, bonds or other investment options to include inside the fund. When a mutual fund is made up of stocks, it’s called a stock mutual fund. What if it’s made up of bonds? Then it’s called a bond mutual fund. You get the idea!

How Does a Mutual Fund Work?

Here’s a good way to visualize how mutual funds work: 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?

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

A typical growth stock mutual fund buys stocks in 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 goes up, so do your returns!

One of the great things about mutual funds is that you don’t need 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.

mutual funds

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’re spreading your investments across many different companies so 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 built-in diversification.

2. Lower Costs

Trading single stocks can get expensive because you can end up paying transaction fees for every single stock you buy and sell. Those fees 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 someone else's work. In this case, they’re copying a stock market index like the S&P 500—they do whatever it’s doing and call it a day.

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Market chaos, inflation, your future—work with a pro to navigate this stuff.

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

Types of Mutual Funds

Let’s take a closer look at the different types of mutual funds. Today, nearly $27 trillion in assets like stocks, bonds, cash and money market accounts are held in more than 7,400 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

Also known as equity 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! To be specific, we recommend investing evenly in four different types of mutual funds:  

  • Growth
  • Growth and income
  • Aggressive growth
  • International

Value Funds

Managers of value funds are the bargain hunters of the investing world. They pack these funds with stocks that seem to be trading for less than they’re actually worth. The idea behind this strategy is that these stocks are “on sale” and will eventually go back up, reflecting their “true value.”

There is a place for value funds in your portfolio (some growth and income funds invest in growth and value stocks). But the problem with value funds is that it can be tough to figure out what a company is truly worth, and whether or not a company will actually recover.

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. 

Index Funds

Index funds are designed to mirror the performance of a particular market index by investing in the companies 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. 

Sector Funds

Sector funds, sometimes called specialty 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.

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.

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What Mutual Funds Should I Invest In?

Now, there are many different types of funds out there, but you should invest 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

These mutual funds have stocks from companies outside the United States—think BMW, Mercedes and LG—helping investors diversify their portfolios by investing their money in global companies of different sizes beyond American borders. By including international funds in your mutual fund portfolio, you can benefit from the success of well-known companies overseas.

How to Invest in Mutual Funds

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 is free money that instantly increases 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 open up a Roth IRA and invest in mutual funds there with the help of an experienced investment professional.

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

How to Choose the Right Mix of Mutual Funds

Within each of the four types of funds we recommend, you’ll need to pick the mutual funds you want to invest in. Like we mentioned earlier, there are thousands of funds out there to choose from—so how do you decide which ones to add to your portfolio? Here are the four main factors to look at when choosing a mutual fund:

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.

You’ll also want to look at the fund’s volatility, which is a measure of how much the fund’s value fluctuates from year to year. Every mutual fund has some level of volatility as values rise and fall with the stock market—funds with high volatility tend to be riskier. But how much is too much? That depends on you and your tolerance for risk.

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. Explore the fund’s fees and expenses.

To figure out what a fund costs, you’ll want to look at its expense ratio. That’s the percentage of your investment you’ll pay each year to own the fund. You’ll also want to look at sales charges, transaction fees and brokerage charges. Depending on the class of fund you choose these costs will vary.

4. 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 we 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.

Work With a Financial Advisor

Still have questions about investment options like mutual funds? Our SmartVestor program can connect you with an investing pro who serves your area. They can answer your questions and help you navigate the ups and downs of the stock market.

Find your SmartVestor Pro today!

Ramsey Solutions is a paid, non-client promoter of participating pros. 

Frequently Asked Questions

There will always be at least some level of risk with investing, but investing with mutual funds is safer than investing in single stocks. Why? Because instead of betting your retirement future on the success or failure of one or two companies, mutual funds help you invest in dozens or hundreds of different stocks all at once.  

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

When you spread your investments evenly across the four different types of mutual funds we recommend (growth and income, growth, aggressive growth, and international) you lower your risk while still taking advantage of the growth of the stock market. It’s a win-win!    

If you own a mutual fund, you’re considered a shareholder. You can make a profit from your investments in one of two ways: through dividends or capital gains.


Dividends are a reward to shareholders for holding onto certain stocks or mutual funds for the long term. Keep in mind, not all stocks offer dividends, and there are several different types. In most cases, dividends are paid quarterly and in cash. You can either pocket the money or reinvest and buy more shares.

Capital Gains

This money is paid out when your investment is sold for a higher price than what you originally paid for it. (That’s why you hear the phrase, "buy low, sell high.") But you don’t get that money until you sell your shares. Until then, your profits (and losses) are merely on paper—not in your pocket.

Just think of it this way: Dividends are paid at least yearly (but often quarterly), while capital gains are paid out when you sell the investment (if you earned a profit).

Though you should never decide on a mutual fund based on fees alone, it’s important to understand the long-term impact of a fund’s fees and expenses. A small difference in fees can make a huge difference in your returns down the road.

There are two types of fees associated with mutual funds: ongoing fees and transaction fees. Under the "shareholder fees" section of the fund’s prospectus, you’ll find both the ongoing fees—which are included in the fund’s expense ratio (cost to operate the fund)—and the transaction fees.

Here’s a breakdown of what’s included in each:

  • Management fee: This fee is what you pay to the fund manager or the team of investing professionals who make sure the fund achieves its investing objective and performs well. Typically, this fee falls between 0.5% and 2% of the assets being managed.
  • 12b-1 fees: These fees pay for the marketing and selling of the fund. They’re capped at 1% of the fund’s assets and are paid directly out of the fund.
  • Miscellaneous: These include accounting fees, audit fees, as well as recordkeeping and legal fees.
  • Transaction fees: These include redemption fees, sales charges and trading fees.

We know that’s a lot to remember, and it can get confusing. That’s one of the reasons we recommend you work with an investment professional. These pros can explain the details and your options in easy-to-understand language.

If a fund doesn’t perform well over the long haul, or if it’s not a good fit for your overall strategy, it may be time to drop that fund from your investing portfolio. Here are some signs to look for when deciding whether to drop a mutual fund. As always, it’s best to talk this decision over with your financial advisor.

1. The expense ratio is too high.

Though you should never choose a mutual fund based on its expense ratio alone, understanding a fund’s expenses is important. Every penny you pay toward expenses and fees is money that’s not in your investment—and it’s not moving you closer to your retirement goals.

2. There’s too much turnover.

When a fund has a high turnover rate (the percentage of the fund’s holdings that are bought and sold each year) it can lead to big fees and costly taxes for funds outside of a retirement account. It also shows that the management team might be trying to time the market for a bigger return.

3. Your portfolio is out of balance.

Over time, as the market fluctuates and shares are bought and sold, your portfolio is bound to change. This may mean you no longer have 25% of your investment in each of the four categories. To get back on track with your strategy, your investment professional can rebalance your funds. This typically happens a minimum of once a year. Remember, balance is the key.

Just like their name suggests, exchange-traded funds—or ETFs—are basically funds that are traded on an exchange. They’re 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.

A Christian mutual fund invests money in companies and causes that line up with Christian values. They usually try to avoid investing in companies that are considered "sin stocks”—things like tobacco, alcohol, gambling and weapons.

It’s always a good idea to understand exactly what you’re investing in and noble to want to invest in companies you believe in. But you still need to do your own homework to make sure any Christian mutual fund you’re considering has a long track record of solid returns, just like you would with any other fund.

Just because a mutual fund invests in companies that align with your views doesn’t automatically make it a good investment!

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros. 

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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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