Building a diversified investment portfolio comprised entirely of individual stocks and bonds isn’t financially feasible for many investors. This is precisely where mutual funds come in, offering an alternative way to gain exposure to numerous stocks, bonds, and other investments within a single fund.

What is a mutual fund?

A mutual fund is an investment company that pools money from investors to purchase a diversified portfolio of stocks, bonds, and other assets: combined holdings collectively known as a mutual fund “portfolio.”

How mutual funds work

Mutual funds are managed by professional money managers whose job is to select investments that match fund goals. In doing so, they follow guidelines outlined in the fund’s prospectus: a document filed with the Securities and Exchange Commission (SEC) that explains the fund’s objectives, strategies, fees, and other important details so you can make an informed investment decision. If a fund’s goal is aggressive growth, for example, the managers will build a portfolio with a mix of investments (e.g., stocks and bonds) that aim to achieve that growth. When you invest in a mutual fund, you buy shares—each one representing a portion of ownership—and thus share in fund profits (or losses) proportionally with other investors.

Active vs. passive mutual funds

A key difference exists with respect to how mutual funds approach investing. While most are actively managed as a traditional way of doing things, others follow a passive strategy that can in turn influence investor returns. Here’s a little bit more about each method…

Active mutual funds

An actively managed fund tasks a team of professional portfolio managers with making investment decisions on your behalf, aiming to outperform the market by carefully selecting which stocks, bonds, or other assets to buy and sell.

Passive mutual funds

Conversely, a passively managed fund aims to match the performance of a specific market index (e.g., the S&P 500) rather than try to beat it. Not relying on a team of managers to choose individual stocks or bonds, this type of fund automatically invests in the same securities that make up the chosen index.

Types of mutual funds

A variety of mutual funds suit various objectives. These include:

Stock funds

A stock fund is a type of mutual fund that invests primarily in stocks (also known as “equities”). When you put your money into a stock fund, you pool your investment with other investors to buy shares of many different companies—giving you instant diversification, which can help reduce risk compared to investing in individual stocks on your own. Stock funds come in many varieties, some focusing on large well-known companies while others invest in smaller, fast-growing businesses or specific sectors such as technology or healthcare.

Bond funds

A bond fund is a type of mutual fund that invests mainly in bonds and other debt securities. As with stock funds, you pool your money with other investors but in this case buy a diverse mix of bonds rather than shares (e.g., government, corporate, or municipal bonds).

Sector funds

A sector mutual fund invests in a specific industry or sector of the economy such as technology, healthcare, energy, or real estate. Instead of spreading investments across a wide range of industries, this type of fund invests most or all of its money in companies from a single targeted industry.

Money market funds

Money market funds invest in short-term debt securities with very short maturities and low risk. Including things like Treasury bills and certificates of deposit (CDs), they’re often used as a cash option in brokerage accounts and are considered very safe—though it’s important to not confuse them with the money market savings accounts offered by federally insured banks and credit unions, which have different protections and features.

Balanced funds

A balanced fund invests in a mix of stocks and bonds to offer both growth and stability. Think of it as a one-stop investment option that aims to give you the best of both worlds: the potential for higher returns from stocks and the steady income and lower risk from bonds.

Target date funds

A target date fund is designed to help you invest for a specific goal (typically retirement) planned for a particular year—your “target date.” In choosing a target date fund, you select the year closest to when you expect to need the money (e.g., 2040 or 2050). Here’s how it works: the fund initially invests more heavily in stocks to help your savings grow and then automatically shifts toward more conservative investments (e.g., bonds and cash) as the target date approaches to help protect what you’ve built.

Why invest in mutual funds?

As with any investment, mutual funds have their pros and cons. Here are some key benefits when it comes to the former:

Diversification

Mutual funds invest in a mix of different stocks, bonds, or other assets. Even if these investments follow a similar style or goal, this variety gives you instant diversification to reduce risk.

Ease of buying and selling

Most mutual funds are easy to buy and sell. You can in fact typically turn your shares into cash within just one business day, making them a flexible investment option.

Professional management

With mutual funds, professional managers do all the heavy lifting: researching, choosing, and monitoring investments so you can invest with confidence without the need to personally track each and every stock.

Dividend and capital gain reinvestment

Mutual funds make it simple to reinvest any dividends or capital gains earned. By automatically adding these earnings to your investment, you can grow your wealth more quickly over time.

Mutual fund drawbacks

Now, let's talk about some of the downsides associated with mutual funds:

Fees and other expenses

While plenty of low-cost mutual funds do exist out there, some still come with higher fees or sales charges (i.e., “loads”) when you buy or sell. These extra costs can chip away at your investment returns over time.

Performance & risk

As with other investments, mutual funds go up and down with the market. Returns might therefore fail to match your expectations—with the potential to lose money as well.

No control over taxable distributions

Mutual funds can send out interest, dividends, or capital gains at any time during the year, actions that can lead to unexpected taxable income if you're holding your fund in a taxable account (e.g., a brokerage account).

Trade execution

Unlike stocks, mutual funds aren't traded instantly but are instead bought and sold at the end of the trading day. This means you might not get the exact price you were hoping for when you placed your order.

Mutual fund costs: what you need to know

One big advantage of mutual funds is their flexibility. After you meet the minimum investment—typically between $1,000 and $5,000—you can invest as much or as little as you want, whenever you want. This makes mutual funds a smart choice for both new and experienced investors seeking to build their portfolios over time.

The price of a mutual fund is called its "net asset value" (NAV) or sometimes NAV per share (NAVPS). You might see it listed as something like "$15.20 (NAV)" or "XYZ Fund: $15.20." Mutual fund prices are updated once a day, after the market closes, and the NAV calculation is simple: take the total value of the fund's investments, subtract any debts, and divide by the number of shares. If a fund has $100 million in assets, $10 million in liabilities, and 5 million shares, for example, the NAV would be ($100M – $10M) / 5M = $18 per share. Mutual fund prices can fluctuate each day given that investments and share quantity constantly change.

How are mutual funds taxed?

You’ll pay taxes on mutual funds twice: when you receive distributions and when you sell your shares.

Taxes on mutual fund distributions

Whenever you receive distributions from a mutual fund (e.g., interest from bonds, dividends from stocks, or capital gains from investments the fund sells), you’ll typically owe taxes on the same. Your fund will send you a Form 1099-DIV or 1099-INT each year, making it easy to report your earnings when you file your taxes.

Taxes when you sell

If you sell mutual fund shares for a profit, the taxes you pay depend on how long you’ve held them. Sell after a year or less, and you’ll pay short-term capital gains tax at the same rate as your regular income tax. Hold your shares for more than a year, and you’ll qualify for long-term capital gains tax rates that are usually lower.

How to reduce or avoid mutual fund taxes

The easiest way to avoid these taxes is to keep your earnings in a tax-advantaged account(s) such as a 401(k), traditional IRA, Roth IRA, or health savings account (HSA) so they can grow tax-free or tax-deferred (depending on account type).

How to choose a mutual fund

Selecting a mutual fund might seem confusing at first, but it doesn't have to be. Here are few factors to consider during your research:

Know your profile

First things first: define your investment goals (long-term growth or stability), timeline (how long you plan to invest), and risk tolerance (how comfortable are you with market ups and downs).

Consider performance

Check out independent resources like Barron’s or Morningstar to compare mutual fund ratings, keeping in mind ratings are often based on past performance that doesn’t predict future fund performance.

Review costs

Mutual fund fees matter! The expense ratio tells you what percentage of your investment goes to management each year, and you should also check for transaction fees or sales loads when buying or selling. Use online tools or review the fund’s prospectus or fact sheet for a clear breakdown of mutual fund costs.

Remember: mutual funds can generate income (from dividends and interest) and capital gains. In looking at the total return, you’re seeing the big picture: a more complete way to measure performance than simply checking the fund’s NAV. After weighing these key factors, you’re ready to choose a mutual fund that fits your unique goals and needs.

How to purchase a mutual fund

To buy a mutual fund, start by opening an investment account (e.g., a brokerage or retirement account like an IRA). You can then select mutual funds on your own or consult a financial advisor for guidance.

Mutual funds vs. ETFs

Both mutual funds and exchange-traded funds (ETFs) are essentially pooled funds that hold a variety of securities (e.g., stocks, bonds, etc.) and are professionally managed, either actively or passively. Differences between mutual funds and ETFs do in fact exist, however, including the following…

Trading flexibility

Mutual funds are bought and sold at the end of the trading day, with the transaction generally settling the following business day. ETFs, meanwhile, trade like individual stocks during market hours.

Minimum investment

While ETFs technically don’t require a minimum investment, they must be purchased as whole shares; if a share costs $400 and you only want to invest $200, for example, you can’t purchase that particular ETF. Mutual funds do often call for a minimum investment (although typically low), and it’s common to own fractional shares.

Tax-efficiency

ETFs usually have a big advantage over mutual funds when it comes to tax efficiency. Thanks to the unique way ETF shares are created and redeemed, they often generate fewer capital gains distributions and thus help investors reduce their tax bills and keep more of their returns.

Management

Most mutual funds are actively managed, while ETFs are often passively managed.

Keep in mind that mutual funds and ETFs are not mutually exclusive for investors looking to build their portfolios. You can certainly choose both types of investments alongside others—such as individual stocks, bonds, and REITs—as building blocks for a diversified portfolio.

In sum: what to know about mutual fund investments

While mutual funds offer an easy way to invest in various asset classes and strategies, it’s important to fully understand fund objectives, corresponding strategy, and all expenses associated with the fund before committing to this investment.

Still have questions about mutual funds and how they fit into your overall investment strategy? Schedule a FREE discovery call with one of our financial advisors to get them answered.

About the author
The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.

Retirement Planning | Advice | Investment Management

A Beginners’ Guide to Mutual Funds