11 MINUTE READ
How are you supposed to build a solid nest egg if you can’t make sense of your options? The best place to go for a complete explanation of your investing options is a financial advisor. But keep this in mind: While your advisor provides education, you’re ultimately the one who calls the shots when it comes to your retirement.
What Are Mutual Funds?
Before we look at how to invest in mutual funds, let’s define what a mutual fund is. When an investor buys a mutual fund, they contribute to a pool of money to be managed by a team of investment professionals. This team selects the mix of stocks, bonds, money market accounts, etc., included in the mutual fund based on the fund’s specific objective.
The major benefit of mutual funds is they allow investors to invest in many different companies at once. If you have a tax-advantaged retirement savings account, like a workplace 401(k) plan or a Roth IRA, that’s the easiest place to start investing in mutual funds.
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How Do You Make Money From Mutual Funds?
When mutual funds increase in value, the profit is shared with the investors. That distribution can then be reinvested to buy more shares of the stock. Those shares make more profit, which can be reinvested and on and on.
The most important factor in making money from mutual funds is investing consistently for a long period of time. How long you keep your money invested is even more important than what funds you choose to invest in!
You want to use a buy-and-hold strategy when investing in mutual funds. Don’t try to time the market by buying and selling based on trends. Choose investments with a long history of above average returns, and stick with them for the long haul.
Are Mutual Funds Safe?
One of the biggest perks of mutual funds is diversification. Because your investment is split between a variety of companies, you don’t have to worry about your account tanking because a single stock underperforms.
But keep in mind, even with the instant diversification mutual funds offer, there’s no guarantee of a certain return when you invest in the stock market. That can be intimidating, but exposing your investment to some level of risk is necessary if you want your money to grow over the long term.
When you ride the waves of the stock market, you’ll have ups and downs. However, historically, most people have seen returns in the long run. Take the S&P 500, for example. The S&P 500 tracks the performance of stocks from the 500 largest, most stable companies in the U.S., and it averaged a 12% annual return from its creation in 1923 to 2016.(1)
If you’re saving money that you plan to use in less than five years, don’t invest it in mutual funds. Just put it in a savings account. But if you’re wanting to consistently invest for the long term, mutual funds are a great option.
How Should I Invest in Mutual Funds?
Follow these simple steps to make smart decisions about investing in mutual funds.
1. Invest 15% of your income.
Wealth-building takes hard work and discipline. Dabbling in investing here and there won’t get you far. If you want to invest for your future, you need to plan on investing consistently—no matter what the market is doing.
Dave recommends investing 15% of your income for retirement. After you’ve paid off all debt except for your house and built a solid emergency fund, you should be able to carve out 15% for your future. It might feel like a sacrifice at first, but it’s worth it. Once you get in the habit of investing consistently, you’ll realize you don’t even miss that money!
There’s no shortcut to building wealth, but there are strategies that can help your money go further. For instance, investing in tax-advantaged accounts through your workplace, like a 401(k), is a great way to get started. And if you get a company match on your contributions, even better!
If you have a traditional 401(k) at work with a match, invest at least enough to get 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). This year, you can invest up to $5,500 for yourself and an additional $5,500 for your spouse if you’re married.(2) It’s possible to max out your Roth IRA without reaching your 15% goal. If that’s true for you, go back to your 401(k) and invest the rest of your 15% there.
Have a Roth 401(k) with good mutual fund options? It’s even simpler. You can invest your whole 15% in that account.
2. Diversify your investment portfolio.
Dave recommends four types of mutual funds and spreading your investment equally across each type. Keeping your portfolio balanced helps you minimize your risks against the stock market’s ups and downs.
Each fund type can respond differently to the same event. That means if one fund is down, another fund could be up.
Brant Spesshardt, an investing professional in Raleigh, N.C., helps explain the four mutual fund categories Dave talks about and the reasons why he recommends them:
- Growth and income: These funds create a stable foundation for your portfolio. Brant describes them as big, boring American companies that have been around for a long time and offer goods and services people use regardless of the economy. With the growth and income, be sure to look for funds with a history of stable growth that also pay dividends. You might find these listed under the large-cap or large value fund category. They may also be called blue chip, dividend income or equity income funds.
- Growth: 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. Common labels for this category include mid-cap, equity or growth funds.
- Aggressive growth: 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. “So small-cap funds are going to qualify—or even a mid-cap fund that invests in small- to mid-sized companies,” Brant says. But size isn’t the only consideration. Geography can also play a role. “Aggressive growth could sometimes mean large companies that are based in emerging markets,” he adds.
- 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 Trader Joes, Firestone and Gerber. 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.
3. Don’t chase returns.
It can be tempting to get tunnel vision and focus only on funds or sectors that brought stellar returns in recent years. But Brant cautions against that strategy.
“Nobody can time the market,” he says. “Investors just have to remember you never want to put all your eggs in one basket. It’s long-term, and you want to try to keep your investments as simple and as boring as possible.”
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 long-haul returns.
Watch now: Dave explains his investing process in a recent episode of The Dave Ramsey Show
4. Brush up on investing lingo.
You don’t have to be an expert in investing lingo to choose the right mutual funds. But a basic understanding of some of the most common terms will help. Here are a few to get you started:
- Asset Allocation: The practice of spreading your investments out (diversifying) among different types of investments with the goal of minimizing investment risk while making the most of investment growth.
- Cost: Be sure to understand the fee structure associated with using a financial advisor. Again, talk with several pros to compare commission structures before you make your decision on a which financial advisor you’ll use. Also, pay attention to the fund’s expense ratio. A ratio higher than 1% is considered expensive.
- Large-, Medium- 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. Medium-cap companies are moderately risky, and small-cap companies are the riskiest—but have the biggest payoffs.
- Performance (Rate of Return): You want a history of strong returns for any fund you choose to invest in. Focus on long-term returns, 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.
- Portfolio: This is simply what your investments look like when you put them all together.
- Sectors: Sectors refer to the types of businesses the fund invests in, such as financial services or health care. A balanced distribution among sectors means the fund is well diversified.
- Turnover Ratio: Turnover refers to how often investments are bought and sold within the fund. A low turnover ratio of 50% or less shows the management team has confidence in its investments and isn’t trying to time the market for a bigger return.
That being said, having a financial consultant help you can really improve your investing portfolio.
5. Find an investing professional.
If Dave has said it once, he’s said it a hundred times: Never invest in anything you don’t understand. No one cares about your future as much as you do, so it’s in your best interest to take charge of your own mutual fund education.
But sometimes you need a little help with translation. And that’s where an investing expert comes in handy.
A good investing professional can help you sort through the lingo and determine whether the mutual funds you think line up with your objectives really do. Be clear about your goals up front to ensure you and your pro are on the same page before you make selections.
Remember to take your time and interview several SmartVestor Pros before you make the decision. Hiring the right financial advisor can make all the difference!
What if you know a lot about investing, and enjoy researching your options on your own? Do you still need an advisor? Yes! In fact, even Dave has an advisor!
Think of your advisor as a coach, yet you call all the shots.
6. Stay involved in your wealth-building plan.
You should always know how your money is invested and what role it plays in helping you reach your long-term goals. After all, this is your future we’re talking about!
Stay engaged with how your funds are performing and regularly rebalance your portfolio. Over time, certain mutual funds can start to take up more and more room in your investment portfolio, which can expose you to risk. Remember, you never want your eggs to all be in one basket. You want that risk spread out evenly between the four types of funds.
You should always be open and honest about any questions you have in your regular meetings with your financial advisor. They can help you create a wealth-building plan and forecast your retirement income based on your whole financial picture.
Talk With an Investing Advisor
If this sounds like a lot of information to dig through and compare, you’re right! The good news is you don’t have to do it all alone. You can work with a SmartVestor Pro who understands that you’re in charge of selecting your own retirement investments.
Find your pro!