Mutual funds offer diversification and lower risk — here’s how they work

Growing your wealth with individual stocks requires extensive research and comes with considerable risk.

A mutual fund allows you to pool your money with other investors to buy stocks, bonds and other securities. Because mutual funds typically involve a larger number of asset types, they diversify your portfolio and reduce your risk with lower costs.

Here's what you need to know about mutual funds, including how they work, how to invest in them and more.

Mutual funds work by pooling money from multiple investors to purchase stocks, bonds and other securities. Because they draw from a collection of companies, they offer immediate diversification at a lower cost — and without having to work with an advisor. Instead of owning shares of the company, however, you own shares in the fund. 

The price of a share is determined by dividing the total value of its assets by the number of outstanding shares. This figure is known as the net asset value.

You can buy shares of mutual funds from a broker, although your 401(k) or other employer-sponsored retirement plan may also invest in mutual funds.

There are many different types of mutual funds. These are some of the most popular.

Index funds

Also known as passive funds, index funds match the performance of a benchmark index like the S&P 500 or the Dow Jones Industrial Average. A mutual fund can be an index fund, but so can an ETF. Because they only have to meet an index, they require less management and usually have lower fees.

Money market funds

Money market funds offer low volatility for an investment product and can be easily accessed (generally the next business day). They can include CDs, bonds, Treasury bills and debt-based and cash equivalent securities — all of which are low-risk investments.
 
Because of their availability and modest return, money market funds are usually considered short-term investments.

Equity funds

Since they're primarily invested in stocks, equity funds are also known as stock funds. They're the most popular form of mutual fund, and can focus on the domestic or international market, on certain sized companies or particular business sectors. Equity funds can also be managed actively or passively.

Target-date funds

Target-date funds are framed around when an investor plans to retire, so they commonly appear in 401(k) plans. These accounts focus on higher-growth, higher-risk stocks early on, but then gradually move to lower-return, lower-risk bonds as you near retirement.

Bond funds

Bond funds feature corporate bonds, Treasury bonds and other debt securities. Because there's a set rate of return, they're also known as fixed-income funds.

While bond funds have less potential for growth than equity funds, they're also considered a safer investment — which makes them one of the most popular types of mutual funds.

You can start investing in a mutual fund through a brokerage firm. If you want to maximize your investment, look for a broker with no transaction fee (a charge for buying or selling shares) and a low expense ratio (the fee to manage the fund).

Fidelity Investments has thousands of mutual funds with no transaction fees (though some may require specific deposit amounts). Fidelity Go®, the firm's robo-advisor, invests in mutual funds with no management fees or expense ratios.

Charles Schwab also offers mutual funds with zero transaction fees and, in 2023, the asset-weighted average of Schwab's expense ratio was only 0.05%. In comparison, the average expense ratio for all bond funds in 2023 was 0.37%, according to the Investment Company Institute. For equity funds, it was 0.42%.

Top robo-advisors like Wealthfront and Betterment will build a portfolio around your risk tolerance, time horizon or investing goals and automatically rebalance your portfolio based on market conditions and the proximity of your investing targets.

Mutual funds and exchange-traded funds (ETFs) both contain stocks, bonds and other assets, but substantial differences exist.  

ETFs are traded throughout the day, so their price can change frequently. Mutual funds are only traded once daily (after the market closes), so their share prices don't fluctuate. 

In addition, ETFs are passively invested, meaning they aim to keep up with a benchmark index like the S&P 500 or the Dow. Mutual funds, on the other hand, are usually actively managed and try to beat the benchmark. As a result, the fees associated with mutual funds are typically higher.

Many mutual funds require a minimum investment, which could range from $500 to $3,000, while ETFs don't have a minimum. 

Distributions from a mutual fund are taxed, whether they're paid out in cash or reinvested. Your brokerage should provide you with IRS Form 1099-DIV after the end of the calendar year. 

If your mutual funds are part of a 401(k) or IRA, you typically don't have to pay taxes until you start making qualified distributions in retirement.

Mutual funds are a good way to diversify where your investing money goes, and passively managed mutual funds like index funds and ETFs (as opposed to actively managed mutual funds) are a more affordable route.

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