How to Invest in Mutual Funds

There’s a lot to love about mutual funds. But after doing some research on your own, you may be feeling a little overwhelmed by all the details and lingo. It’s easy to get confused!

First, take a deep breath. Once you get past all the fancy investment jargon, you’ll see that mutual funds really aren’t all that complicated. In fact, you can start investing in mutual funds with these five easy steps:

1. Calculate your mutual fund investing budget.
2. Open up tax-advantaged retirement accounts for your mutual funds.
3. Research and narrow down your mutual fund choices.
4. Choose your mutual funds.
5. Manage your mutual funds.

Don’t worry—we’re going to help you cut through the noise and walk through each step. That way, you’ll know exactly what mutual funds are and how to invest in them . . . the right way.

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?

A typical growth stock mutual fund buys stock in dozens, sometimes hundreds, of different companies—so when you invest in mutual funds, you’re basically buying bits and pieces of all those companies at once.

Once you’re invested, the value of some company stocks may go up while others go down—you know, the usual stock market dance—but the overall value of the fund should go up over time. And as the value of the fund goes up, so do your returns.

How to Invest in Mutual Funds

Now it’s time to get down to business! If you’re ready to start investing in mutual funds, just follow these simple steps and you’ll be well on your way:

1. Calculate your mutual fund investing budget.

After you’ve paid off all your debt (except for your house) and built a solid emergency fund, invest 15% of your gross income every month in retirement.

Why budget 15% of your income for investing? Why not more or less? Because we’ve seen millions of Americans become Baby Steps Millionaires by saving 15% consistently over time while still having enough money for other important financial goals—like saving for their kids’ college and paying off their house early. If they could do it, so can you.  

For example, if you have a $65,000 salary, your goal is to invest about $800 every month. Depending on the performance of your mutual funds, here’s what could happen if you invest that amount in mutual funds from age 35–65:

• $800 per month from age 35–65 at 10% return is $1.8 million.
• $800 per month from age 35–65 at 11% return is $2.2 million.
• $800 per month from age 35–65 at 12% return is $2.8 million.

These numbers assume a $65,000 annual household income from age 35–65. This means that even if you never get a raise, never switch to a higher-paying job, and never receive an employer match throughout your career, you can still retire as a millionaire. A freaking millionaire!

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

You see, building wealth takes hard work and discipline. If you want to invest for your future, you need to plan on investing consistently—no matter what the market is doing.

2. Open up tax-advantaged retirement accounts for your mutual funds.

Your mutual funds have to go somewhere. If you have access to a tax-advantaged retirement savings account—like a workplace 401(k) plan or a Roth IRA—that’s the best place to start investing in mutual funds.

And if you get a company match on your 401(k) contributions, even better. That’s free money and an instant 100% return on your investment, people! But don’t count the match as part of your 15% goal. It’s nice to have, but it’s just the icing on the cake of your own contributions.

If you ever get confused about where to start investing, just remember: Match beats Roth beats traditional.

If you have a traditional 401(k) at work with a match, invest up to the match. Then, you can open a Roth IRA. With a Roth IRA, the money you invest in mutual funds goes further because you use after-tax dollars—which means you won’t have to pay taxes on that money when you withdraw it in retirement. It’s all yours!

The only downside to a Roth IRA is that it has lower contribution limits than a 401(k).¹ It’s possible to max out your Roth IRA without reaching your 15% goal. That’s okay. Just go back to your 401(k) and invest the rest of your 15% there.

Have a Roth 401(k) with good mutual fund options? Even better. You can simply invest your whole 15% in that account and boom—you’re done!

3. Research and narrow down your mutual fund choices.

Listen, you don’t have to be an expert in investing lingo to narrow down the right mutual funds for you. A mutual fund’s prospectus—a written document that provides key details about the fund—or online profile will tell you a lot of what you need to know.

Here’s a little prospectus cheat sheet to get you started:

• Objective: This is simply a summary of the mutual fund’s goal and how the fund’s management team plans to achieve that goal.
• Fund manager experience: You want a seasoned manager with at least 5–10 solid years of experience under their belt. However, many managers mentor their successors for several years—so don’t write off a new one too quickly if the fund has consistently performed well.
• Cost: Make sure you understand the fee structure your financial advisor uses to get paid. We recommend choosing front-end load mutual funds, where you pay fees and commissions up front so your money can grow uninterrupted. Also, pay attention to the fund’s expense ratio. A ratio higher than 1% is generally considered expensive.
• Sectors: Sectors refer to the types of businesses the fund invests in, such as financial services or health care. A fund is well-diversified if it invests in a good mix of sectors.
• Performance (rate of return): Again, you want a history of strong returns for any fund you choose to invest in. Focus on long-term results—10 years or longer if possible. You’re not looking for a specific rate of return, but you do want a fund that consistently outperforms most funds in its category.  
• Turnover ratio: Turnover refers to how often investments are bought and sold within the fund. A low turnover ratio of 10% or less shows that the management team has confidence in its investments and isn’t trying to time the market for a bigger return.

Now that we’ve narrowed down your mutual fund choices, let’s go over a few other handy terms you’ll probably come across:

• Portfolio: This is simply what your investments look like when you put them all together.  
• Asset allocation: This is the practice of spreading your money out (or diversifying) among different types of investments—things like stocks, bonds, real estate, and other holdings with monetary value—with the goal of minimizing risk while making the most of investment growth.  
• Large-, mid- and small-cap: Cap stands for capitalization, which means money. To most investors, though, it refers to the size and value of a company. Large-cap companies carry lower risk, but you’ll make less money. Mid-cap companies are moderately risky, and small-cap companies are the riskiest—but have the biggest payoffs.  

Getting familiar with these terms will help you feel a little more comfortable as you make investing decisions with your investment professional.

4. Choose your mutual funds.

When it comes to investing, the last thing you want to do is treat your retirement portfolio like the Kentucky Derby and bet it all on one horse. That’s why you should spread your investments equally across four types of mutual funds: growth and income, growth, aggressive growth and international.

That keeps your portfolio balanced and helps you minimize your risks against the stock market’s ups and downs through diversification. Diversification just means you’re spreading your money out across different kinds of investments, which reduces your overall risk if a particular market goes south.

Below are the four mutual fund categories we talk about and the reasons why we recommend them:

• Growth and income (large-cap): These funds create a stable foundation for your portfolio. They can be described as large, well-known (big and boring) American companies that have been around for a long time and offer goods and services people use regardless of the economy.  
• Growth (mid-cap): This category features medium or large U.S. companies that are experiencing growth. Unlike growth and income funds, these are more likely to ebb and flow with the economy. For instance, you might find the company that makes the latest "it" gadget or luxury item in your growth fund mix.
• Aggressive growth (small-cap): Think of this category as the wild child of your portfolio. When these funds are up, they’re up. And when they’re down, they’re down. Aggressive growth funds usually invest in smaller companies with lots of potential. 
• International: International funds are great because they spread your risk beyond U.S. soil and invest in big non-U.S. companies you know and love, like Toyota, Samsung and Nestlé. You may see these referred to as foreign or overseas funds. Just don’t get them confused with world or global funds, which group U.S. and foreign stocks together.

It can be tempting to get tunnel vision and focus only on funds or sectors that brought stellar returns in recent years. Just remember, nobody can time the market or predict the future (unless you happen to have a time-traveling DeLorean parked in your driveway).

Before committing to a fund, take a step back and consider the big picture. How has it performed over the past five years? What about the past 10 or 20 years? Choose mutual funds that stand the test of time and continue to deliver strong returns over the long haul.

5. Manage your mutual funds.

There’s a reason why most millionaires we talked to for The National Study of Millionaires said they worked with a financial advisor to achieve their net worth.

A good investment professional can help you manage your investments in two ways. First, they can help you pick and choose what mutual funds to include in your retirement portfolio. Be clear about your goals up front so you and your pro are on the same page before you make any decisions.

Second, they can help you stay engaged with your investment strategy. Every once in a while—maybe once a year or once every quarter—it’s a good idea to set up a meeting or a phone call with your financial advisor to see how your mutual funds are performing and whether you need to make any changes to your portfolio.

And remember: Be patient and don’t obsess too much over your portfolio. The key to successful investing is patience. There’s no reason to panic when the stock market is down. No matter how bad things have gotten, the market has recovered every single time. So put your phone down, turn the news off, and take a deep breath. Don’t give in to fear. Trust the proven process.

What Are the Main Benefits of Mutual Funds?

As we’ve touched on, mutual funds come with awesome benefits built in—all of which can help make them a solid investment vehicle for folks trying to save for retirement. Here are three big ones:

Lower Costs

One of the best things about mutual funds is that you don’t need a lot of money to get started—some funds don’t even have a minimum investment requirement. Trading single stocks, on the other hand, can become a bit more expensive since you could wind up paying fees on each individual stock you buy. It adds up fast.

Instant Diversification

We’ve all heard it many times before: “Don’t put all your eggs in one basket.” That’s diversification in a nutshell—spreading your investments across many different companies, which reduces your overall risk.

Like we mentioned, mutual funds can come prepackaged with hundreds of different companies, making it easy for investors—especially those starting out—to diversify from the beginning.

Active Management

Index funds and most exchange-traded funds (ETFs) have a sort of “set it and forget it” approach to investing. The goal of these investments is to match the performance of the S&P 500—nothing more, nothing less.

Mutual funds, on the other hand, are run by a team of investment experts who set out to beat the stock market’s returns. They set the fund’s strategy, do their research, monitor the fund’s performance, and make adjustments as needed.

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.