Introduction
Investing can seem intimidating, especially if you’re just getting started. But mutual funds offer a simple way to dip your toe into the stock market through professionally managed, diversified portfolios. In this beginner’s guide, we’ll walk through what exactly mutual funds are, their different types, their costs, and how to select funds that match your financial goals. By the end, you’ll understand the basics of building a balanced mutual fund portfolio.
What Are Mutual Funds?
A mutual fund is an investment vehicle that pools money from many individual investors to purchase a diverse mix of stocks, bonds, and other securities. Instead of having to pick and choose which companies to invest in, mutual funds allow you tap into expertise of professional fund managers to build you a diversified portfolio.
Mutual funds make money in two ways:
- Through appreciation of their underlying assets like rising stock prices
- By distributing dividends from companies in their portfolio back to investors
Some key advantages to investing in mutual funds include:
- Diversification: Mutual funds invest across dozens or hundreds of securities across various sectors, industries, and companies. This reduces your exposure to risk associated with any single investment.
- Affordability: The minimum investment to buy into a mutual fund can be as low as $1,000 or less, allowing easy portfolio diversification.
- Professional management: Fund managers and researchers choose and manage investments full-time. This can be a better option than going it alone for beginning investors.
- Simplicity: Mutual funds handle all trades, rebalancing, and regulatory compliance behind the scenes without investor involvement.
- Flexibility: From conservative bond funds to aggressive sector-specific funds, there’s a mutual fund for every investment goal.
As you can see, mutual funds offer new investors an accessible path towards diversified investing while leaning on professional expertise. Next, let’s explore some of the most common categories of mutual funds.
Types of Mutual Funds
There are over 10,000 mutual funds to choose from in the United States covering a range of assets, sectors, geographies, industries, and more. While variety can be great, it also adds complexity. So it helps to first understand the major mutual fund types that cater to different investment strategies and risk profiles:
- Stock Funds – Primarily invest in stocks across various sectors, market caps, growth rates, industries, and volatility levels. They offer high long term return potential along with heightened short term risk.
- Bond Funds – Invest predominantly in fixed-income securities like government, corporate, or municipal bonds. They prioritize income and stability over growth.
- Money Market Funds – Focus on ultra short-term debt investments that can be liquidated quickly. They provide higher returns than savings with marginally increased risk
- Index Funds – Aim to mimic returns of benchmark indices like the S&P 500. They offer diversified, low maintenance investing at very low costs.
- Target Date Funds – Mix of assets that adjust over time to become more conservative as the target retirement year approaches. This “set it and forget it” option is ideal for long-term retirement investing.
- Sector/Specialty – Concentrate on specific sectors like technology or healthcare. Only suitable for tactical bets rather than core long-term holdings.
As a beginner, stock and bond mutual fund combinations can create a solid portfolio foundation. Adding small allocations to specialty sector funds can provide growth upside. Index funds also deserve special consideration thanks to rock bottom fees and foolproof diversification.
Risk Tolerance and Time Horizons
Before selecting any mutual funds, it’s critical to clarify your risk tolerance and investment timeline. Risk tolerance comes down to how much volatility you can stomach. If the thought of your portfolio dropping 30% has you sweating, a heavy stock allocation may not be advised. Investment horizon considers your timeframe for needing to access your invested money. Retirement savings have a timeline of 20+ years, while a house down payment fund may only have a 5 year horizon.
Once you objectively assess your ability and willingness to endure risk over different periods, you can choose mutual funds aligned to those goals. Aggressive growth funds may be acceptable for early retirement savings decades away while bond funds are better suited for near term tuition needs.
Costs to Consider
While mutual funds simplify investing, they do not come free. Funds charge for their management and operating expenses through an expense ratio capped around 2% (but often lower). This yearly percentage fee is automatically subtracted from fund assets daily.
Funds may also charge fees when you buy or sell shares directly. Selecting no-load mutual funds avoids these transaction costs. Of course lower expense ratios mean more of your money goes towards actual investing rather than overhead. Index funds shine here with fees at around 0.1% or less in many cases.
Studies show that cost minimization can be among the most reliable predictors of superior long-run mutual fund returns. That said, cheaper is not always better. More expensive actively managed funds can sometimes justify their higher fees through metrics like benchmark beating performance, lower volatility/drawdowns, or exceptional service. The key is assessing whether you’re getting sufficient value for the costs.
How To Pick Winning Mutual Funds
The thousands of mutual fund choices available make selection challenging. You could spend months poring over past performance data and holdings trying to project future returns. However, academics have determined that historical returns generally do not predict future performance.
A better approach is to focus more on risk management, diversification, and cost minimization. Start by outlining your overall asset allocation encompassing domestic stocks vs international exposure, bond classes, sector tilts if any, and cash levels. Top fund screening criteria include:
- Strong long-term track record spanning multiple market environments
- Performance better than 50-70% of peer funds in its category over 5-10 years
- Risk-adjusted returns exceeding its benchmark over time
- Expense ratios below category average
- Low turnover of holdings and tax efficiency for non retirement accounts
It also helps sticking to reputable mutual fund companies that provide a broad set of options like Vanguard, Fidelity, and Schwab. Going with an allocation of low-cost index funds and sprinkling in some actively managed funds where advisable is prudent for new investors.
Sample Diversified Mutual Fund Portfolio
Now that we’ve covered mutual fund investing basics, let’s walk through components of a balanced, beginner portfolio:
40% U.S Stock Fund (S&P 500 Index) Tracks the broader domestic large cap stock market with rock bottom fees under 0.1%. Holding the SPDR S&P 500 ETF (SPY) is a popular alternative.
20% International Stock Fund (Total International Index)
Cost-efficient exposure to developed and emerging market foreign stocks across cap sizes. Vanguard FTSE All-World ex-US ETF (VEU) provides similar foreign coverage.
25% Investment Grade Bond Fund (Core Total U.S Bond Market Index) Low-cost diversified U.S bond market exposure covering all maturities and credit qualities. Individual bonds can also create a laddered portfolio.
10% Mid-Cap Stock Fund (Mid-Cap Growth Mutual Fund) An actively managed mid-cap stock picker that outperforms its benchmark and could boost returns.
5% Small-Cap Stock Fund (Small-Cap Value Index) Small-cap value stocks offer an alternative source of growth less tied to large cap indexes. Can be dropped for simplicity.
This sample portfolio gives you widespread, low-cost diversification across major assets with sprinklings of tactical active funds targeting less efficient areas of the market. Altogether it keeps risk moderate while still providing growth upside. New investors should resist the urge to overload on speculative funds in hot sectors and instead master balanced asset allocation.
Automated Investing Platforms
To complete your mutual fund portfolio, you’ll need brokerage and bank accounts to purchase funds and hold cash balances. Leading investment apps like Robinhood, M1 Finance, and Betterment provide convenient online tools for investing in mutual funds with automated deposits, dividend reinvesting, rebalancing, tax optimization, and more. They allow creating a diversified fund portfolio without paperwork headaches. Even established brokerages like Fidelity and Vanguard now offer robo-advising services pairing algorithmic investment management with human support on demand.
Investment apps help implement a passively managed “set and forget” fund portfolio aligned to your goals. Automating weaknesses like emotional reactive trading, lack of portfolio rebalancing, and cash drag from uninvested dollars can bolster returns over the long run. Easy to use retirement platforms like blooom also provide tailored fund recommendations and ongoing portfolio oversight to improve your chances of a comfortable nest egg.
Just Starting Out
The intelligent use of low-cost stock and bond mutual funds can help beginners gain comfort with market investing, build diversified holdings across assets, and reach long-term wealth building goals. Taking time to assess your risk tolerance, return objectives, and investment horizon is crucial to tailoring a mix of funds suited to your needs. Establishing balances across equities and fixed income while minimizing costs lays groundwork for superior risk-adjusted returns over time. Investment apps further simplify launching and managing your customized fund portfolio with automated tools. So don’t let investing seem intimidating. Mutual funds offer new investors an accessible onramp towards growing and preserving wealth over decades.