What are mutual funds and how do they work?

Two young women sitting outside reading together on the same tablet about mutual fundsImage: Two young women sitting outside reading together on the same tablet about mutual funds

In a Nutshell

A mutual fund is an investment pool that uses money from many people to invest in securities like stocks, bonds and short-term debt. Mutual funds may help you reduce risk by making diverse investments — but there are drawbacks, too. You may have to pay fees, and you won’t be able to choose where the fund invests your money.
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Not sure how to start investing on your own? Putting your money into a mutual fund means you won’t be going it alone.

A mutual fund is a company that allows a pool of people to invest by buying shares in the fund. The company uses that pooled money to invest in a variety of stocks, bonds and other securities. By doing this, the mutual fund allows its customers to build diverse investment portfolios without having to buy their own individual stocks or bonds. This approach can cost less than you might pay to buy a variety of securities on your own.

If you’ve built up an emergency fund and are doing well managing debt, you might feel ready to begin investing. A mutual fund can be a good place to start if you want to save money for retirement or other goals.

Let’s look at how mutual funds work and how they can help you progress toward your savings and investing goals.

How do mutual funds work?

Mutual funds are managed by companies that must register with the Securities and Exchange Commission, or SEC. When you invest in a mutual fund, you purchase shares in the fund, either from the fund itself or through a broker or other investment professional. Each share represents your percentage of ownership of all the investments in the mutual fund’s portfolio.

Your investment in a mutual fund can make you money in a few ways.

If the fund sells securities during the year and makes a profit (called a capital gain) off that sale, it might distribute those gains (minus capital losses) to shareholders at the end of the year. Or the securities in the fund’s portfolio might pay dividends, which are distributed to investors.

Finally, if the market value of the mutual fund’s portfolio increases, your shares’ value could also increase — although that money would be “on paper,” rather than in your pocket, unless you sold your shares at the higher price.

Learn about saving for retirement

When your shares make you money, you’ll usually have the option of asking for a check (or other type of payment) or reinvesting your payoff to buy more shares in the fund.

Mutual funds can allow investors to diversify their investments more easily and cheaply than if they tried to do so on their own. And diversifying your investments can mean less risk of loss than you might have if you put all your money in just one or two investments.

What makes mutual funds different from other types of investments?

Mutual funds have several features that set them apart from other types of investments.

Mutual fund share classes

Some mutual funds allow investors to tailor their experiences by choosing among different classes of shares. Each share class has its own fees, services and expenses, and each one performs differently. But be aware that your broker or adviser will likely be paid different fees for each class of shares they sell.

Professional management

Mutual funds are typically managed by professional investment advisers who choose what products the fund will invest in. Funds can be either actively or passively managed.

Advisers of actively managed funds may buy or sell fund investments every day in an effort to maximize the fund’s performance. But there’s no guarantee they’ll succeed, and actively managed funds tend to have higher management fees since you’re basically paying for the skill and expertise of the fund manager.

You can also choose a “passively managed” fund, or index fund, which doesn’t try to beat the market to provide higher returns in the short term. Management fees are typically lower for passively managed funds.

What are some types of mutual funds?

There are multiple types of mutual funds, and they’re generally classified based on the types of securities they invest in. Here are some (but not all) types of mutual funds to consider.

Stock funds

  • Invest primarily in stocks (also known as equities)
  • Fluctuating stock prices can make performance rise and fall
  • May perform better over the long term since stocks historically perform better over time than other types of investments

Bond funds

  • Higher risk/return than money market funds
  • Invest primarily in various types of bond purchases

Money market funds

  • Relatively low-risk funds
  • Invest primarily in safer, short-term investments like U.S.-based corporations and government entities

Balanced funds

  • Also known as asset allocation funds
  • A mostly fixed combination of stock funds, bond funds and money market funds

Target date funds

  • Also known as lifecycle funds
  • Created with a set end or retirement date
  • A mix of stocks, bonds and other securities that changes over time

What are the pros and cons of investing in mutual funds?

Like any type of investment, mutual funds have advantages and disadvantages. If you’re thinking about investing in mutual funds, assess for your own situation whether the value of the advantages outweighs the potential disadvantages.

Pros of investing in mutual funds

  • More opportunity for growth — Deposit accounts like savings, checking and certificates of deposit are generally considered safe. But interest rates on these investments tend to be low. People may put money into investments like mutual funds in the hopes of getting a higher rate of return on their money.
  • Low startup costs — Some mutual funds set low minimums for the amount you’re required to purchase, which gives you the opportunity to start investing without a lot of cash. And some may also have low prices to purchase additional monthly shares.
  • Professional management — Investing can be confusing, and you might welcome some professional help. If you invest in an actively managed fund, a professional manager should research investment vehicles and make informed decisions about which ones to invest in and monitor how well the fund is doing over time.
  • Liquidity — Some types of investments limit when you can access your money. But when you invest in a mutual fund, you can redeem your shares on any business day. Mutual funds must then send payment for the shares within seven days.

Cons of investing in mutual funds

  • Fees — Mutual funds allow you to sell your shares whenever you want, and redeem the net asset value, or NAV, for your shares. But that net value is what you get after paying fees. Mutual funds can charge investors sales charges, annual fees, management fees and other costs — and you’ll pay them even if your mutual fund investment loses money.
  • Capital gains tax If you receive a capital gains distribution from your mutual fund, that money could be subject to capital gains tax.
  • Not backed by the FDIC — Unlike some other investment tools, mutual funds aren’t FDIC insured, which means you could potentially lose some or all of the money you invest if your fund performs poorly.
  • Less control over investments — The fund company decides where to put your (and your fellow shareholders’) money. You may want a say in where your money gets invested for a number of reasons. For example, you may be concerned about the environmental or social impact of your investments. If so, consider looking for a mutual fund that practices sustainable, responsible and impact investing, or SRI.

Common question: What is the capital gains tax rate?

How do I start investing in mutual funds?

If you have an employer-sponsored retirement account, like a 401(k), chances are you’re already invested in a mutual fund. If you’re ready to open an additional account on your own, here are a few steps to consider before you begin investing.

Start by looking at how much risk you can afford to take when you invest. You can determine your “risk tolerance” on your own or with the help of an investment professional, based on variables like your current age, retirement age and whether you’re on a fixed income.

While you want to know how well a mutual fund you’re considering has performed in the past, keep in mind that past performance isn’t necessarily the best way to predict how the fund will perform in the future. Weigh the fund’s past performance along with other factors like how long the fund has been in business and the size of the fund.

Research any representative you’re considering working with to see if they’re licensed and registered, or if they have any negative records. You can look this info up through the Securities and Exchange Commission at investor.gov.

Finally, take extra care to review all of the fees a mutual fund charges. A difference in costs between funds may seem small, but those costs can add up over time. You can find information about fees, risks and more in a mutual fund’s prospectus.

Bottom line

When investing, the general rule of thumb is that higher returns often equal greater risk. Diversifying your investments can be one way to help mitigate risk, and mutual funds can help you diversify easily and cost-effectively.

Remember that investing often takes time to pay off. Pay down debt, build up an emergency fund and maximize your contributions to your 401(k) (if you have one) before delving into the world of investing.

About the author: Sarah C. Brady is a San Francisco–based financial consultant, workshop facilitator and writer. In addition to writing for Credit Karma, Sarah writes for Experian, LendingTree, Magnify Money, MSN News and more. In her … Read more.