A mutual fund pools your money with other investors’ to buy a wide mix of stocks and bonds, offering you diversification without the hassle of selecting individual companies yourself. In my opinion, index funds are the best type of mutual fund, since they track the market at low cost and consistently deliver strong long-term performance.
How Mutual Funds Actually Work
When you invest in a mutual fund, you are buying shares of the fund itself, not the individual stocks or bonds it owns. This means you become a partial owner of everything in that portfolio.
Think of it in terms of pizza: Investing in a mutual fund is like buying a slice of a giant pizza instead of making your own pizza from scratch with individual ingredients that you purchase separately.
Mutual funds are popular because they let you invest in a broad mix of stocks and bonds through a single purchase. You get to diversify your investments without the hassle of having to pick and manage dozens of individual stocks on your own.
Net asset value and daily pricing
Mutual funds are priced once per day, after the market closes, using the net asset value (NAV). The NAV is calculated by adding up the total value of all the securities in the portfolio (every stock, bond, and other investment the fund owns), subtracting any expenses, and dividing by the number of fund shares outstanding. The fund’s value changes throughout the day based on how its investments perform, but you only get one official price at the end of each trading day.
For example, if a fund owns $100 million worth of stocks and bonds, has $1 million in expenses, and has $10 million in shares, the NAV would be $9.90 per share.
Unlike individual stocks, which you can buy and sell throughout the day at changing prices, mutual funds only trade once daily, at the closing NAV price. This means if you place an order to buy or sell fund shares at 2 p.m. EST, you will not know the exact cost until the market closes at 4 p.m. EST.
Fund managers and their role
Most mutual funds are run by a fund manager who chooses all the investments in the portfolio. This is a major benefit for novice investors who lack experience and prefer to entrust their money to an expert.
Fund managers have teams of researchers and analysts who help determine which stocks and bonds to buy or sell based on company performance, market trends, and economic conditions. Because these managers actively handle your money, these funds are often called actively managed funds. Fund managers charge a range of fees for their work, which we will cover in detail later.
Fund managers have a strong incentive to perform well, since their careers and bonuses often depend on the fund’s performance. In some cases, they can receive bonuses of up to millions of dollars if they perform well. Despite this, most fund managers fail to consistently beat the market, which is why I recommend index funds as a simpler, more reliable option.
How to Actually Invest in Mutual Funds
You can start investing in mutual funds through your retirement account or a regular brokerage account in just about 15 minutes. Here’s a quick breakdown on how to get started.
Start with retirement accounts for tax advantages
Your retirement accounts, such as a 401(k) or Roth IRA, let you invest in index funds while enjoying major tax benefits.
A 401(k) is an employer-sponsored plan where you contribute a portion of your paycheck before taxes are taken out. Many employers even match a percentage of your contributions, which is practically free money for you. Check out this guide to learn how a 401(k) works and why it’s one of the easiest ways to grow your money.
A Roth IRA, on the other hand, is a type of account you open through a brokerage using after-tax money. The best part about this is that your investments grow tax-free for life. You can find the best IRA accounts to open in this article.
Always max out your retirement accounts first before investing in taxable accounts, where you’ll owe taxes on your investment gains each year.
Choose a trusted brokerage
You can invest in mutual funds through banks, credit unions, or brokerage firms. These companies let you buy and sell investments like mutual funds, stocks, and bonds through their platforms. Some of my favorite brokerages include Vanguard (the one I personally use), TIAA, and Charles Schwab. Each of these brokerages offers a great variety of index funds, so you really can’t go wrong with any of them.
Vanguard is especially popular for its low-cost index funds for a very good reason. It was founded by John Bogle, the man who first invented index funds. If you’re interested in diving deeper, check out this guide on the best Vanguard index stock and bond funds.
When choosing a brokerage, look for one that offers commission-free trading, low or no account minimums, and a wide selection of mutual funds so you can start investing right away.
Once you’ve chosen a brokerage, it’s incredibly easy to open an account. Typically, all you’ll need is your Social Security number, your employer’s address, and your bank details (account and routing numbers).
Then, you can start the application process:
- Step 1: Go to the website of your chosen brokerage.
- Step 2: Click on the “Open an account” button.
- Step 3: Select “Individual brokerage account” and start the application.
- Step 4: Fill in your personal details, including your name, address, birth date, employer information, and Social Security number.
- Step 5: Set up an initial deposit by entering your bank information.
- Step 6: Wait for a few days. The initial transfer usually takes three to seven business days to complete.
- Step 7: Once your account is funded, log in and start investing.
Choose your first fund
If it’s your first investment, a great place to start is an S&P 500 index fund. It’s simple, diversified, and has a proven track record of consistent performance over decades.
The S&P 500 tracks the 500 largest publicly traded companies in the United States, including household names like Apple, Microsoft, and Amazon. By buying one share of a S&P 500 index fund, you’re effectively buying a tiny piece of all 500 of those companies in one single transaction.
When comparing funds, choose the one with the lowest expense ratio. This is the annual fee charged as a percentage of your investment; ideally, it should be under 0.1%. For instance, Vanguard’s S&P 500 index fund (VFIAX) charges only 0.04%, which means you pay just $0.40 per year for every $1,000 you invest.
If you want to explore more options, feel free to check out my guide on the best mutual funds.
How You Actually Make Money from Mutual Funds
Mutual funds earn you money in three primary ways: through dividends, capital gains, and share price growth. Here’s how each one works.
Dividend and interest distributions
If a mutual fund holds assets that pay dividends (money a company pays to its shareholders), the fund manager passes those earnings to the fund’s investors. These distributions can also come from bond interest or capital gains earned within the fund.
Dividends are typically paid quarterly as a way for profitable companies to share their earnings with shareholders. When the stocks in your fund pay dividends or the bonds pay interest, that money goes to you, either as cash or as an automatic reinvestment into more shares.
Most investors choose to reinvest these payouts to take advantage of compound growth over time. This means your distributions allow you to buy more shares, which in turn generate even more distributions, creating a snowball effect that steadily grows your investment over decades.
Capital gains from selling securities
When a fund manager sells stocks or bonds that have gone up in value since the fund bought them, the profit from that sale is called a capital gain. For instance, if the fund bought Apple stock at $100 per share and sold it at $150, that $50 difference per share is a capital gain.
These gains are distributed to investors once or twice a year, and you’ll owe taxes on them even if you choose to reinvest the money instead of taking it as cash. This is one of the downsides of mutual funds compared to some other investments, since you’re taxed on profits you haven’t actually received in your bank account.
Selling shares for profit
You can also make money when you sell your mutual fund shares for more than you originally paid. If you bought shares at a NAV of $50 and later sold them at $75, you’d earn $25 per share in profit.
Over time, this share price growth (combined with compound growth) is where most of your long-term returns will come from, especially if you hold your funds for decades in a retirement account. When I look at my own Vanguard account, most of my gains come from the fund’s increasing share price rather than from quarterly dividend payments.
The Main Types of Mutual Funds
Each type of mutual fund serves a distinct purpose, offering different levels of risk and potential return.
Stock funds
Also known as equity funds, stock funds invest in shares of many different companies. They come in three main categories: large-, mid-, and small-cap funds. “Cap” here stands for market capitalization, which is the total value of a company’s stock, calculated by multiplying its share price by the number of shares outstanding.
- Large-cap funds invest in established companies like Apple or Google, with market values over $10 billion. These funds tend to offer more stability but slower growth, since the companies are already well established.
- Mid-cap funds target medium-sized companies that are still growing but not as large as major corporations. They offer a balance between risk and reward.
- Small-cap funds invest in smaller companies valued under $2 billion. They have higher growth potential but also higher volatility, as smaller businesses can be more vulnerable to market changes.
Stock funds can also focus on specific sectors (like technology, healthcare, or energy) or regions (such as Europe, Asia, or emerging markets). To learn more about the different types of stocks, check out this in-depth guide.
Bond funds
Bond funds, also called fixed-income funds, invest in various types of bonds, which are essentially IOUs issued by governments or companies: You lend them money, and they pay you back with interest over time.
These funds typically offer higher returns than money market funds but carry more risk, particularly from interest rate fluctuations (when rates rise, bond values tend to fall).
- Government bond funds invest in Treasury securities and other government-backed debt. They’re considered the safest bond investments because the U.S. government has never defaulted on its debt.
- Corporate bond funds invest in debt issued by companies. They offer higher potential returns than government bonds but carry greater risk; if a company faces financial trouble, it may be unable to repay the money.
Bond funds generate steady income through interest payments, making them popular among retirees and anyone looking for consistent cash flow.
Money market funds
Money market funds invest in high-quality, short-term securities issued by governments (such as U.S. Treasury bills) or corporations (such as commercial paper). Because these investments are very stable, money market funds carry the lowest risk and therefore offer the lowest returns.
They’re often used as a temporary holding place for cash you plan to invest soon or as an alternative to an emergency fund that earns slightly more than a traditional savings account. These funds aim to maintain a stable $1 per share value, so your account balance stays steady rather than fluctuating like stock funds.
However, money market funds aren’t FDIC-insured like bank savings accounts, which means there’s a very small chance you could lose money if something catastrophic happens. If you’re considering your options between money market funds vs. savings accounts, this guide might be helpful.
Balanced or hybrid funds
Hybrid funds combine stocks, bonds, and other investments to offer both growth and stability. Some even invest in other mutual funds. Yes, that means mutual funds inside mutual funds.
These funds automatically rebalance between stocks and bonds to maintain a target allocation, such as 60% stocks and 40% bonds, adjusting as market values change.
A popular example is target-date funds, which gradually become more conservative as you approach retirement. If you see a fund with a year in its name, like “2045 Fund” or “2050 Fund,” it’s designed for investors planning to retire around that year. These funds start off with mostly stocks when you’re younger and slowly shift toward bonds to reduce risk as you near retirement.
Index funds
Index funds are a unique type of mutual fund that are passively managed, meaning they track a market index automatically instead of relying on a fund manager to pick stocks.
An index is simply a list of companies grouped together, such as the S&P 500 (the 500 largest U.S. companies) or the Dow Jones (30 major industrial companies). The most popular index funds track the S&P 500, which includes companies like Apple, Microsoft, Amazon, Alphabet, and hundreds of other major corporations.
Other index funds track broader markets, such as the total U.S. stock market (comprising thousands of companies) or international markets (giving you global diversification).
Index funds have much lower fees than actively managed funds because they don’t require expensive managers or research teams to make the stock picks; they just follow the index automatically. If you’re considering this option, here’s my simple guide to investing in index funds.
Why Index Funds Beat Actively Managed Mutual Funds
Contrary to what many people believe, index funds often outperform actively managed mutual funds, and they do so with much lower fees. Here’s how.
The performance numbers tell the truth
According to Dow Jones, most mutual fund managers fail to beat the S&P 500; the results are even worse for mid- and small-cap funds. And this isn’t just a case of bad fund managers. In fact, these are professionals with teams of analysts, sophisticated software, and decades of experience who still struggle to consistently outperform a simple index.
Even the few managers who beat the market one year rarely repeat that performance the next, which makes it almost impossible for investors to predict in advance which funds will succeed.
Expense ratios compound against you
Mutual funds charge an annual fee called an expense ratio, usually ranging from 0.25% to 2%. This fee is deducted from your returns automatically and covers the fund manager’s salary, administrative costs, and marketing expenses.
Over a few decades, even a 1% fee can cost tens of thousands in lost compound growth on a typical investment. Index funds, on the other hand, charge only between 0.03% and 0.20%, meaning you keep more of your returns instead of paying them to the fund managers who might not be able to beat the market anyway.
Load fees are pure waste
A load fee is a commission paid to the financial advisor or salesperson who sold you the fund. It does not affect the fund’s performance. For example, a 5% front-end load means that $500 of every $10,000 invested goes straight to the salesperson.
Thousands of excellent no-load funds exist, so there is absolutely no reason to pay these fees. No-load funds also tend to outperform load funds over time. My advice? Avoid load funds no matter how “worth it” a financial advisor claims they are.
If you’re new to investing, I discuss active and passive investing in this beginner’s guide.
Advantages and Disadvantages of Mutual Funds
Mutual funds offer real benefits, but index funds give you those benefits while avoiding most of the drawbacks.
Benefits that apply to all mutual funds
In general, mutual funds are a great investment option. Here’s why:
- Mutual funds are hands off, so you don’t have to manage your investments on a day-to-day basis.
- They hold many stocks, so if one company performs poorly, it won’t drag down your entire investment.
- They provide diversification, spreading risk across dozens or hundreds of companies.
- You can start investing with relatively small amounts of money compared to building a diversified portfolio of individual stocks.
- Professional management means you don’t need to research companies, read earnings reports, or track market news constantly.
Drawbacks that mostly affect actively managed funds
While all mutual funds have benefits, actively managed funds come with some downsides you should be aware of:
- Many funds charge an expense ratio and possibly upfront fees to pay for professional management.
- Investing in multiple funds that overlap holdings reduces diversification. For example, if two of your funds both hold Microsoft and the stock crashes, you take a double hit. This is avoided with an index fund tracking the entire market.
- Fund managers rarely outperform the market, meaning you may be paying for expertise you do not benefit from.
- Capital gains distributions create tax bills even if you do not sell any shares, which can be frustrating in taxable accounts.
- Some funds require high minimum investments, anywhere from $3,000 to $10,000, which can be a barrier for new investors.
Why index funds solve most of these problems
Index funds carry lower risk while still offering strong long-term returns. Because there are no fund managers or sales-load fees, and expense ratios are much lower, you keep more of your investment gains. Investing in the entire market also reduces volatility, which means your returns grow more steadily over time.
The only downside is slower short-term growth. But, this can actually be an advantage as it helps prevent panic-selling during market downturns, a common mistake among new investors.
The Bottom Line on Mutual Funds
Mutual funds make it easy to invest in a diversified portfolio without picking individual stocks, which is why they are so popular in retirement accounts. The problem is that most actively managed mutual funds charge high fees and rarely outperform the market, making them a less effective option. Index funds address these issues by tracking the entire market with minimal fees, no sales loads, and consistent long-term performance.
Start with a simple S&P 500 index fund, set up automatic monthly investments, and let compound growth work for you over time instead of trying to beat the market or time your purchases.
By investing wisely in index funds, you can steadily grow your wealth over time and build a financial foundation that supports the Rich Life you envision.
