How mutual funds work: Basics for new investors

Mutual funds have long been a popular investment choice for new and more experienced investors. They offer a simple way to diversify your portfolio without requiring you to select individual stocks or bonds. By pooling money from multiple investors, mutual funds provide access to a broad range of assets overseen by professional fund managers. This makes it easier to spread risk and potentially increase returns.

Whether you're saving for retirement or other goals, it's worth considering whether mutual funds could benefit your investment strategy. Let's take a look at the basics of how to invest in mutual funds and how they make money.

A mutual fund is a collection of stocks or bonds chosen and managed by professional money managers. Mutual funds give individual investors access to a diversified mix of stocks and bonds they may not be able to invest in otherwise. Mutual funds can be building blocks for your financial future by helping you save for retirement, build wealth and stay ahead of inflation.

Mutual funds allow you to buy many stocks and bonds at once by purchasing a single investment. Instead of having to research and choose which individual company stocks or bonds to buy, mutual funds help you quickly build a diversified portfolio of investments.

Mutual funds are professionally managed by experts who make educated decisions regarding which underlying investments to purchase. Instead of building your own portfolio of stocks and bonds—which might lose value or underperform compared to other investments—mutual funds benefit from professional investment advice.

Mutual funds make money for investors primarily through capital appreciation and income distributions.

• Capital appreciation. The value of the fund's shares increases as the value of its underlying investments grows. Mutual funds often sell stocks or bonds as part of an overall investment strategy; every time the fund sells a stock or bond at a profit, it earns a capital gain. These gains are paid out to the mutual fund's shareholders. Dive deeper into how capital gains work

• Income distributions. When a mutual fund invests in assets that generate income, such as bonds (which earn interest) or stocks (which sometimes pay dividends to investors depending on the company), the mutual fund pays out those earnings to its shareholders.

As a mutual fund investor, you own little pieces of many different companies, and every time your mutual fund makes money, you make money too. That said, mutual funds can lose value during periods of stock or bond market weakness.

The price of mutual funds is based on the fund's net asset value (NAV) or the total market value of all the assets contained in the fund. If a mutual fund holds $10 million of stocks and bonds (the fund's assets) and has 1 million shares, each share is worth $10.

Let's say hypothetically that you decide to buy 10 shares of the mutual fund for $100. If the mutual fund's assets gain 10% ($1 per share) in value during the next year, your 10 shares would be worth $110 ($11 per share).

The prices of mutual funds, like the price of stocks and bonds, can go up or down each day based on overall market conditions and demand. Most mutual funds have some amount of investment risk and volatility—stocks and bonds can go up or down in price, and mutual funds are made up of stocks and bonds. If you're willing to accept the risk of ups and downs in your mutual fund's day-to-day price, you may find your investment collects long-term gains.

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People invest in mutual funds for several reasons—to save time and money with a low-cost investment, to diversify their investment portfolio, to meet various financial goals and for the professional management. Here are five reasons to consider investing in them.

Mutual funds are generally considered an easy, relatively low-cost way for people new to investing to get started. There is typically a low barrier to entry and low minimum investment.

You might, for instance, be able to start investing in mutual funds for as little as $50. Some funds may even have no minimum requirements. This is possible because mutual funds are constantly buying and selling large quantities of stocks and bonds, and the fund gets to pay lower transaction costs than an individual investor would typically pay.

Instead of buying individual stocks or bonds (and paying the costs yourself), you're pooling your money with hundreds or thousands of other investors at a time as part of a larger mutual fund. In this way, mutual funds provide significant economies of scale and reduce costs for everyday people who want to invest in the stock and bond markets.

Mutual funds give anyone the ability to buy lots of stocks and bonds all at once in a pre-selected package instead of picking individual stocks, which can be risky and time-consuming. Mutual funds help you buy into the financial markets without having to research individual companies, decide which stocks or bonds to buy or worry about when to sell. Investing in mutual funds helps you tune out the noise of the stock market's daily fluctuations, so you can focus on your long-term financial future.

Diversification is an investment strategy that can help minimize the chance of large losses by spreading it out among various assets. This strategy helps you put your investment in the best position to reach your goals by capitalizing on the upside of the stock and bond markets while managing risk.

Mutual funds in particular can help you diversify your investments in a few different ways:

• Owning varied assets. With mutual funds, you're building a diversified portfolio of bonds, stocks and cash, depending on your investment goals.
• Owning varied stocks or bonds. Mutual funds allow you to invest in different categories of stocks, such as growth vs. value stocks, in companies of all sizes in the U.S. or international markets as well as in bonds from governments or corporations.
• Owning varied mutual funds. You even can diversify your portfolio by owning multiple mutual funds, such as a potentially higher-risk (but higher-reward) growth stock fund and a less-risky fixed-income bond fund.

Mutual funds are a great way to diversify your portfolio with a targeted, balanced percentage of stocks and bonds based on your risk tolerance and financial goals. You can even pick ones that do this automatically—target date mutual funds gradually adjust the percentages of stocks and bonds as the years go by.

Mutual funds can be designed with a wide range of asset allocations for different investment strategies, financial goals, life stages and risk tolerance. If you are investing money that you don't need right away and you can afford to wait a few years for your investments to go up in value, you might want to invest in a more aggressive mutual fund with a higher percentage of stocks.

If you are already in retirement, you might need a more conservative mix of investments that generate income with a higher percentage of bonds and a lower percentage of stocks. If you're saving money for your child's college education that's eight years down the road, you might want more moderate mutual funds (with a balanced blend of bonds and stocks) than you would choose to invest in for your own retirement that is still 25 to 30 years away.

Another advantage of mutual funds is that they offer high liquidity. That means they're easy to sell at any time. In case your financial plans change, or you need to convert some of your stock and bond investments to cash, owning mutual funds makes it easy to keep your money accessible.

Mutual funds are professionally managed by portfolio managers, experts who research companies, know the markets and are responsible for making the best-informed recommendations for where their clients should invest money. Think of a mutual fund as having a built-in financial advisor who's on your side, managing your money and looking out for your long-term financial interests.

Whether you're saving for retirement, saving for college or trying to grow your money for short- or long-term financial goals, mutual funds with flexible mixes of stocks and bonds are available to help your money work harder for you.

When choosing which mutual fund to invest in, one of the biggest decisions to make is whether to go with active or passive management. Here's how the two compare.

Actively managed mutual funds are run by professional money managers who are regularly involved in choosing stocks, bonds and other investments for the fund's money. With active management, your money is being invested by financial experts who are attempting to generate a return on your investment based on the fund's goals. For example, some funds might have a goal of maximizing growth (and might own a higher percentage of volatile stocks) while some funds might have a goal of generating income (and might own a high percentage of interest-paying bonds and cash).

• Advantages of active management: You might earn a higher return on investment than you would gain from owning a simple index fund.
• Drawbacks of active management: It is hard for most professional money managers to beat the market for many years in a row, and actively managed funds are generally more expensive than passively managed or index funds.
  

With passively managed mutual funds, your money is invested in a diversified portfolio of stocks, bonds or cash with the goal of matching the performance of a broad index, such as the S&P 500. While actively managed funds try to "beat the market" by outperforming the broader stock market, passively managed mutual funds are only trying to earn the same return as the overall index. Passive investing requires less time, attention, research and hands-on work than the active management approach. Instead of trying to pick stocks, a passively managed index fund simply buys all the stocks at once.

• Advantages of passive management: It's an easy way to invest: You can set it and forget it.
• Drawbacks of passive management: You might miss out on gains by settling for only the broad market return.

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When learning how to invest in mutual funds, it's crucial to understand the various types, which are categorized by the way they invest or the assets they hold, such as stocks or bonds.

These funds invest in stocks, which are shares of ownership in companies. They seek growth by investing in companies that are expected to increase in value over time or by sharing profits with investors by paying dividends. These mutual funds are generally suitable for investors with high risk tolerance and long-term time horizons.

Bond funds invest in bonds, which are loans to governments or corporations that pay interest over time. These funds focus on generating regular income with lower risk compared to stock funds, making them suitable for more conservative investors.

Balanced funds invest in a mix of stocks and bonds to provide both growth and income. They seek to balance risk and reward by diversifying across different types of investments, making them a moderate-risk option.

Index funds try to match the performance of a specific market index, like the S&P 500. They generally invest in all the stocks or bonds that make up the index, offering broad market exposure with low fees. These funds are great for investors seeking a low-cost, hands-off approach.

Money market funds invest in short-term, low-risk securities such as Treasury bills and commercial paper. They are designed to provide safety and liquidity, making them a good place to park money that you might need in the near future.

Sector funds focus on a specific industry or sector, like technology, health care or energy. These funds allow investors to target growth in a particular area of the economy. They come with higher risk due to lack of diversification.

These funds invest in companies or bonds outside your home country. International funds focus on non-U.S. investments, while global funds include U.S. and international investments. They offer exposure to global markets, which can add diversification but also increase risk.

Target date funds are designed for investors planning to retire around a specific year (the "target date"). These funds automatically adjust the mix of stocks, bonds and other investments to become more conservative as the target date approaches, providing a hands-off option for retirement planning.

Now that you understand how to invest in mutual funds, you can get started, which can begin with opening an account online with Thrivent or another financial or investment company, or work directly with a financial advisor. You also likely have the option to invest in mutual funds through your 401(k) or other retirement savings plan at work.

Read the fine print about each mutual fund to make sure you understand its investment mix, and decide whether it's appropriate for your goals.