Mutual funds offer investors a convenient financial instrument that enables them to gain exposure and diversify across multiple asset classes within a single investment. Investor capital and resources are pooled together into a single pot that a fund manager invests on behalf of all shareholders.

While an investor could easily recreate a mutual fund portfolio, the number of transactions involved would result in lots of commission fees. In most cases, investing in a fund is more cost-effective than replicating one through individual positions.

How to invest in Mutual Funds

Buying and selling shares in a mutual fund is a relatively straightforward process, even for beginners. Here are the main steps involved:

1. Open a brokerage account

Before making any investments, a brokerage account is required. This provides individuals access to the financial markets through a broker and can be used to invest in mutual funds.

However, it’s worth pointing out there are multiple different types, each suitable under different conditions. Investors should spend time researching which brokerage account is most appropriate for their personal circumstances.

• Standard Account – This is the most common type of investment account. Investors deposit capital which can then be used to invest in an array of financial products, including stocks, bonds, mutual funds, trusts, and ETFs. In the United Kingdom, all capital gains and dividends received through investments in a standard trading account are subject to tax.
• Employer-Sponsored Retirement Account – This is a special type of investment account which has certain tax benefits. However, withdrawals from this account are limited until investors reach a certain age. They are designed to be a saving instrument for pensions. The most common type of employer-sponsored retirement account in the United States is a 401(k).
• Stocks and Shares ISA – This is a special type of tax-efficient investment account for British investors only. All capital gains and dividends received from investments within a Stocks and Shares ISA are tax-free. However, investors are limited to depositing a maximum of £20,000 per year.
• Self-Invested Personal Pension (SIPP) Account – This is a special type of tax-deferred investment account for British investors only. Capital gains and dividends received from investments are protected from tax. However, investors cannot withdraw any funds until reaching the age of 55 (57 from 2028). When funds are taken out, they are taxed as regular income.

2. Define investment goals

Once a brokerage account has been opened and funded, the next step is for an investor to define their investment goals. Knowing precisely what they are aiming for and what risks they are willing to take makes identifying an appropriate collection of mutual funds far easier.

While mutual funds are typically diversified instruments, the risk profiles can vary greatly, as do the investment strategies.

3. Pick a Mutual Fund

With investment objectives clearly defined, investors must select which mutual fund or funds they want to invest in. With thousands of mutual funds to choose from, it can take some time to identify the best options.

However, the search can be quickly narrowed down by selecting the type of mutual fund that best matches an investor’s goals.

• Stock Fund – Invest in equities of publically traded companies. These tend to be higher risk but also offer more growth potential.
• Bond Fund – Invests in various forms of fixed-income assets, including government and corporate debt. These tend to be lower risk than stock funds but typically generate significantly lower returns.
• Balanced Fund – Invests in a combination of stocks and bonds in a fixed ratio. The ratios can vary between funds. Those more concentrated in stocks tend to be at higher risk but offer greater potential returns.
• Money Market Fund – Invests in various debt instruments with short maturity dates. These are typically low-risk but offer mediocre returns that are slightly ahead of a savings account.
• Target Date Fund – Invests in various financial assets, including stocks, bonds, and money market instruments, to balance risk and reward. The composition of the investment portfolio becomes more conservative over time as its investors grow older and eventually reach retirement.

4. Buy shares in the mutual fund

With a brokerage account opened, investment goals defined, and the right mutual fund identified, investors can now buy shares in their selected fund.

These shares trade on the stock exchanges like the London Stock Exchange and New York Stock Exchange. However, unlike regular stocks, trades in investment funds are settled at the end of the trading day.

The price paid per share is equal to the net asset value (NAV) divided by the total number of shares outstanding. The price of mutual fund shares is updated at the end of each trading session.

There may also be additional fees to pay, such as an entry charge defined by the mutual fund. Investors should carefully study the fees charged by a selected fund to understand the true cost of an investment.

Can I lose money from mutual funds? 

All financial investments are exposed to a certain level of risk. And mutual funds are no exception.

The risk of losing money by investing in a mutual fund depends on the type and strategy deployed by the fund manager. In other words, some funds are riskier than others.

However, there are some specific risks investors are exposed to when buying shares in certain types of mutual funds. These include:

• Price Fluctuation – The price and value of a mutual fund share are derived from the fluctuating price of its investment assets. In particular, stock funds focused on growth shares are known to be more volatile. It’s possible for the share price of a mutual fund to drop significantly within a short space of time.
• Value Depreciation – This risk is most familiar with bond funds. Economic forces such as inflation and interest rates can negatively impact the value of debt instruments. Consequently, a drop in the value of bonds can significantly impact the share price of bond funds, even those which have been historically stable.
• Default Risk – Fixed-income mutual funds that invest in debts of corporations and governments are exposed to the risk of default. If a debtor cannot pay the interest or principal on their loans, it can compromise the value of a bond and result in lost income for shareholders.

Alternative investments to mutual funds

Mutual funds are one of many financial instruments available to investors in the pursuit of growing capital.

Some popular alternative includes:

• Stocks – Invest directly into publically traded companies.
• Bonds – Invest directly into buying debt from companies or government institutions.
• Exchange Traded Fund (ETF) – Invest through a cost-effective investment vehicle to gain exposure to a wide range of financial assets.
• Index Fund – Invest in low-cost funds that replicate the average performance of the stock market.
• Real Estate – Invest in property with a traditional mortgage or through various real-estate financial instruments such as a real estate investment trust (REIT).
• Private Equity – Invest in shares of companies within the private sector. This is typically only available for high-wealth individuals or institutional investors.
• Hedge Funds – Invest capital into a fund that uses complex financial instruments, such as derivatives, to achieve market-beating returns.
• Venture Capital – Invest in start-up businesses. This is exceptionally high risk but, if successful, could generate ginormous returns. . This is typically only available for high-wealth individuals or institutional investors.

The Bottom Line

Investing in a mutual fund provides a lot of convenience for investors. Apart from having an instantly diversified portfolio, investors also enjoy the benefits of having a professional investment manager take care of all the research and portfolio management, effectively putting investments on autopilot.

However, this convenience comes at a cost in the form of ongoing management fees. And the returns generated by a fund once fees have been subtracted may fail to meet expectations, let alone outperform a benchmark index. Therefore, investors need to carefully consider the risks as well as potential rewards before committing to a mutual fund investment.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Prosper Ambaka does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.