Economy & Jobs

An Introduction to Mutual Funds for First-Time Investors

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Many middle-class families assume investing is a rich man’s game. You need money to do it, and the stock market often seems like a private club with its own jargon. It doesn’t have to be that way, though. Even the most timid of new investors can find stock-market success with mutual funds.

What Is a Mutual Fund?

Mutual funds allow investors to pool their money to buy a variety of investments. A professional money manager then determine the best use of that money. These funds provide an easy way to diversify your investments. If one investment does poorly, the others can help offset the risk.

Many funds charge sales commissions and management fees, however, and their overall performance depends on how good your fund manager is. For this reason, it’s a good idea to invest in a no-load mutual fund, which charges no transaction fee for its purchase. These loads/commissions otherwise might be charged up front, at the back end, or annually over the life of the investment.

How Do Mutual Funds Work?

Given the many types of mutual funds available, you have the option to focus on a single asset class, such as stocks or bonds, or invest in a variety of types. In addition, you can choose the type of growth or sector in which you would like to invest. There are four primary types of funds:

  • Money Market Funds: These low-risk funds yield the lowest returns. They are legally required to invest in high-quality, short-term U.S. investments.
  • Bond Funds: Also known as fixed-income funds, bond funds are somewhat more risky than money market funds. They only purchase bonds, which represent a company’s debt. In effect, bond investors loan their money to companies in exchange for regular interest payments (also known as dividends) and a return of their principal upon the bond’s maturity. The higher the interest, the riskier the fund.
  • Stock Funds: Stock funds, also referred to as equity funds, offer the greatest level of risk as well as the highest potential return. The many types of equity funds include sector funds, growth funds, and index funds. Each type maintains a portfolio of stocks that share certain characteristics. In general, a beginner investor should stick to index funds, which are constructed to replicate the movement of an index such as the S&P 500. Index funds are statistically more likely to provide growth, and their fees remain low because little management is necessary.
  • Hybrid Funds: These funds invest in a mix of stocks, bonds, and other securities.

Mutual funds are not like individual stocks, in which investors purchase shares from one another, and there are a finite number of shares available. Instead, you’ll purchase directly from the fund, which will create new shares to be sold to new investors. You can sell your shares back to the fund at any time.

How Much Should You Invest?

For new investors, figuring out how much to put into mutual funds can be a nerve-wracking decision. Ultimately, your mutual fund purchases need to take into account the amount of money you have available for investing, your risk tolerance, and your investment time line.

If you feel uncertain about investing, it’s OK to start small. For instance, you could first invest $1,000 and add more as your comfort level increases. Eventually, you may want to automate the process and add a little more each month so your investments continue to grow.

Emily Guy Birken is a former educator and respected personal finance writer. She is the author of the best-seller The Five Years Before You Retire, and the forth-coming book Choose Your Retirement. Her work has appeared on Huffington Post, Yahoo Finance, Business Insider, MSN Money, and Kiplinger's, and Birken has been a guest on Wisconsin Public Radio as well as several podcasts, including Stacking Benjamins and The Doughroller.Birken's background in education allows her to make complex financial topics relatable and easily understood by the layperson. Her mix of no-nonsense advice, humor, and research into the latest studies on finance and behavior make her work a go-to resource for anyone hoping to get a better handle on money matter.