Investing can be a confusing thing. Especially when you don’t know what you’re doing.
Mutual funds are a great way to start. They give you exposure to different types of investments, all in a single fund. Think of a mutual fund as your ‘all-inclusive’ investment option.
For instance, you can buy a target-date mutual fund that contains an entire portfolio and automatically rebalances based on your age. You could buy a fund that focuses on technology stocks. Or, say you’re looking for something low risk because you plan to retire soon. You could invest in a fund that buys bonds. There are plenty of options.
Of course, you don’t have to buy mutual funds on your own. Roboadvisors use algorithms to automatically invest your money in a diversified portfolio. By ceding control, you gain a ton in convenience. But if the thought of giving up control over your assets gives you hives, then there are lots of online brokers who will let you purchase mutual funds on your own.
Once you’ve decided you want to go it alone, you’ve got a lot decisions to make.
How to pick a mutual fund
Choosing a mutual fund isn’t something that you should take lightly. Spend some time making sure the investment is right for you.
Bill Barker of The Motley Fool says your mutual fund shopping list should consist of these four things:
- No sales charges (front loads, contingent deferred sales loads, level loads)
- A low expense ratio, below 1 percent
- Low turnover, no higher than 50 percent a year, and preferably closer to 20 percent
- Full investment policy. Cash reserves of nearly 0 percent
Sales charges are fees you pay to invest in or sell the fund. This is a fee that the firm managing the fund will charge, so it’s in addition to any brokerage fees. Barker says, and I agree, to avoid any funds that charge you sales charges (often called loads).
The expense ratio is what percentage you’ll be charged each year by the fund managers for managing the mutual fund. Index funds, which aren’t usually actively managed, typically have the lowest expenses.
Mutual funds, since they’re managed by someone, will have higher fees. Look for an expense ratio under 1 percent, but try to find one as low as you can that still meets your investment needs. Learn more about how mutual funds are priced before committing.
Turnover is how often the fund manager churns and burns stocks. Meaning, how often they change up the investment portfolio.
I’ve stressed the importance of buying and holding stocks before, so why wouldn’t you want your fund manager to do the same? Here’s an easy way to look at it:
If the turnover ratio is 100 percent, that basically means the fund managers are buying a whole new basket of stocks for the fund each year. They’re turning over 100 percent of the investments each year.
Barker suggests you look for a turnover ratio closer to 20 percent. I’d use that as my max. I’m a huge fan of buy and hold.
High turnover could be a sign that they fund manager isn’t confident in their investment choices. It could also show that they’re impatient or they don’t necessarily have your best interests in mind.
Some fund managers get a bonus based on the fund’s performance each year. This may not correlate with long-term, buy-and-hold strategies.
Finally, you want to be sure that you know the full investment policy of the fund. How do they pick funds? Who is the fund manager? What are their long-term goals?
Understanding the ins and outs of how a fund operates is important, especially because all funds run with different goals.
With cash reserves, having it close to 0 percent means that nearly all the fund’s assets are invested. I look at low cash reserves as confidence, too. Many times funds will keep reserves as a safety net for when there’s a crash or their fund doesn’t do too well. For more information on choosing a mutual fund, check out our full breakdown.
How to buy a mutual fund
By now you’ve selected a broker. You’ve also figured out your strategy and chosen a fund to invest in.
Now it’s time to put your money where your mouse is (allow me at least one corny online investment pun!). When you go to invest, there are a few things you should be familiar with:
Minimum required investment
If you’re a new investor, most likely there will be a minimum investment amount. Sometimes it’s $1,000, sometimes it’s $10,000. It’s up to the fund managers. Some companies will waive this minimum investment if you set up a minimum automatic monthly deposit of $100 or so. This only applies if you buy the mutual fund directly from the company (for example, you buy a Fidelity fund directly, as opposed to buying that same mutual fund from another broker like TDAmeritrade or E*TRADE). Finally, remember that if you stop your automatic investment before reaching the fund’s minimum investment, the company may charge you a low balance fee at the end of the year.
A word of advice: If you like a fund and it meets your needs, wait until you have the money to invest in it. It’ll be more of a hassle to invest in a fund that you don’t want only because you can afford it.
There’s not necessarily a correlation between the minimum investment and the quality of the fund. So don’t let this be a determining factor in whether you invest in a particular fund.
Understanding net asset value (NAV)
A mutual fund’s net asset value (NAV) is the per share price of the mutual fund, calculated at the end of each trading day based upon market movement of the mutual fund’s composite securities. Unlike stocks and exchange-traded funds, most mutual funds are priced like this—just once a day.
When you buy a mutual fund, you will be basing your purchase decision based the NAV at the end of the last market close, however the actual trade price will be based upon the next calculated NAV, which could be higher or lower than the prior day’s NAV.
For example, you could place a mutual fund order at noon, but it may not actually go through until the end of the day, or the next business day. This could have an effect on the value of the fund. For instance, if the market crashes during the day, you may get a deal. If it skyrockets, you could be getting less bang for your buck.
Keep in mind, even though the fund’s NAV could rise or fall prior to your order’s execution, the dollar amount of your transaction will not necessarily change. Unlike with stocks and ETFs, with mutual funds you can purchase a fixed dollar amount.
For example, let’s say you place an order for a $1,000 investment into the Freedom Fund. That day, the Freedom Fund’s NAV is $100. The market declines 2 percent that day, the Freedom Fund’s new NAV might be $98. So instead of your $1,000 buying 10 shares of the Freedom Fund, your money would get you about 10.2 shares of the Freedom Fund. Conversely, if the market went up 2 percent that day, the fund’s NAV would be $102 and your $1,000 would only buy you about 9.8 shares.
NAV changes do not reflect fund performance
One final note: Changes in a mutual fund’s NAV over time does not necessarily give you an accurate indication of the fund’s performance. That’s because a mutual fund pays out most of the capital gains and dividends it receives. Look for a fund’s annual total return when evaluating performance.
When you sell a stock or ETF, you get access to your cash (to withdraw or reinvest) as soon as the order clears—almost immediately. Mutual funds, however, require a settlement period. When you are selling a mutual fund, the settlement period is how much time will pass before you can re-invest (or withdraw) the proceeds from the fund. The settlement period is often between one and three business days.
Trading commissions and other fees
One final consideration when you buy a mutual fund are trading fees. If you purchase a mutual fund directly through the management company (for example, a Vanguard fund from Vanguard or a Fidelity fund from Fidelity), most funds don’t have a trading fee. (Read carefully, however, as some funds do charge transaction fees for buying or selling, even when purchased directly). In addition, many online brokers such as Ally or TD Ameritrade offer a selection of “no transaction fee mutual funds” that you can trade commission-free. You may also be able to buy funds that aren’t in this program, but the broker will charge you a trade commission for buying and selling shares. Sometimes, this mutual fund trade commission will be higher than the commission the broker charges for trading stocks and ETFs.
One of the best brokerages offering no-fee mutual funds is E*TRADE – they have over 4,400 no-transaction-fee mutual funds, so you’ll be able to buy and sell the funds you want without having to worry about commissions cutting into your profit margins.
As I discussed above, know exactly what it will cost to invest. Avoid load fees and go for a broker with free mutual funds or reasonable trade fees.
Other fees to watch out for are short-term redemption or short-term trading fees, applicable if you sell or trade a mutual fund within 60 or 90 days of purchase. In most cases, it would be silly to ever pay these fees because a mutual fund is intended to be a long-term investment.
After that, enter in how much you want to invest (or how many shares) and invest!
Investing in a mutual fund often requires a lot of research, but it doesn’t have to be complex as long as you know what to look for. Follow these simple steps and you’ll be a mutual fund investor in no time.
Be sure to check in as often as you’d like to see how your funds are performing, too. Remember, there are going to be ebbs and flows to the stock market so don’t freak out if you are losing money right away. Think long-term!
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