How to Invest in Mutual Funds

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Today’s post aims to answer a question from one of our readers. She knows she should be investing in the market using mutual funds, but she’s not sure what funds to choose. If you’re left wondering how to select mutual funds or how to find what options are available to you, this is YOUR guide on how to invest in mutual funds. And if you haven’t already, check out our article How to Start Investing: A Beginner’s Guide before reading this one!

What is a Mutual Fund?

Before I dig into the nitty-gritty of how to invest in mutual funds, let’s start with some basics. You are left with countless choices of stocks and bonds once you decide to invest. You could buy a share of Apple, Tesla, or Best Buy. Or if you want to purchase a bond, maybe you buy a municipal bond or a treasury bond. 

But there’s a problem with this approach.

Let’s say your portfolio consists of 3 stocks, each of which make up 1/3 of your portfolio:

• Apple
• BP
• Best Buy

Now, let’s take a worst-case scenario. BP has an oil spill. Their stock drops by more than 50%. Your portfolio has just declined in value by more than 16%. 

I use the BP example because it’s real. BP stock did drop by more than 50% in the 40 days following the Deepwater Horizon oil spill. This sort of catastrophe can happen to any company (most recently Boeing). 

And the reality is, choosing individual stocks is hard to do well consistently, particularly when black-swan events can blow up your portfolio. 

Diversification

You may be asking yourself how to protect yourself from this risk. The answer is simple:  diversification.

Let’s assume that instead of having three stocks in your portfolio of equal weighting, you have 20 stocks of equal weighting. If BP were one of those 20 stocks and fell by 50%, your portfolio as a whole would only be down by 2.5%.

Without getting into the details of financial theory, it takes around 30 stocks to diversify away most single-stock risk. Now just because you have 30 stocks doesn’t mean you don’t have risk – you still do. But this is the systematic risk (i.e., the risk that cannot be diversified away; inherent in investing in stocks). However, having at least 30 stocks in your portfolio helps you mitigate unsystematic risk (single-stock risk).  

The Mutual Fund Solution

Now that I’ve explained the problem with single-stock risk, let’s explore how a mutual fund helps you diversify. A mutual fund is merely a basket of stocks. 

So, if you want to buy five stocks, you could buy each of them individually. Or, you could invest in a mutual fund that contains those five stocks, and you now own shares in each of these companies through the mutual fund.

Mutual funds often hold large numbers of companies in a basket, allowing you to achieve diversification without a whole lot of effort.

For our discussion, I am going to focus on just one kind of mutual funds:  passively managed mutual funds. 

What is a passively managed mutual fund?

When you start researching how to invest in mutual funds, you will come across two kinds of mutual funds:  actively managed and passively managed. An actively managed fund means that there is a fund manager that is trying to pick individual stocks that they think will outperform the market. 

Let me be blunt:  actively managed mutual funds stink. There is an Everest-sized mountain of empirical evidence that active fund managers fail to outperform the broader market over the long term.

Passively managed funds aim to track a benchmark. So, for example, an S&P 500 index fund will aim to follow the stock performance of 500 large companies in the United States. 

I can hear you already. You don’t want to perform as well as the market – you want to beat the market. Sorry, this isn’t reality. No one. And I mean no one. No one outperforms the market over long periods.

Passively managed funds generally track their underlying benchmark target very closely by holding most of the stocks within that benchmark (e.g., an S&P 500 index fund holds most of the 500 stocks in the S&P 500). 

And without going down a rabbit hole on my tirade against actively managed funds, there is another benefit to passively managed funds:  they are usually cheap. Actively managed funds often charge more than 1% per year in fees (to pay that underperforming fund manager and a whole host of other expenses). 

So, if you invest $1,000, every year, the fund is eating $10 off the top. Doesn’t sound like much? What if your total return is 7% per year ($70). Your fund just ate $10 out of the $70 you earned (14+% of your profits). 

Passively managed funds are usually much cheaper (0.2% or less). 

I’ll dig deeper into the weeds another day on index funds, but for now, trust me. Ignore actively managed funds and limit your investments to passively managed funds where possible.

How to Invest in Mutual Funds:  Asset Allocation

Okay, so we’ve established that passively managed (index) mutual funds are a winner. Now we need to outline some basic categories.

Passively managed funds come in all shapes and sizes.

Types of mutual funds include:

• Stock vs. Bond
• Domestic vs. International
• Large-Cap vs. Small-Cap (big companies vs. small)
• Sector-specific (think an oil & gas mutual fund; don’t bother with these)
• Etc.

Portfolio Allocation

As you evaluate these options, start with a generic portfolio weighting of stocks and bonds.

In general, the younger you are, the more risk you can afford to take (as your investments have more time to grow). If you’re younger, weight more heavily towards stock investments. 

If you are looking for a starting place, take 100 minus your age, and this is a target stock allocation. So, if you’re 25, this would mean 75% stock and 25% bond. I think this is a bit conservative, but if you’re risk-averse, it’s a solid starting place.

In your 20s, if you want to do 90 – 100% stock, you can afford to take that risk (if you are willing to stick with it even when the market gets ugly). As you get older, though, you’ll want to start scaling back this risk by increasing your bond exposure.

Let’s assume for our example that you are 25 and are planning to allocate to 90% stocks and 10% bonds. 

You now need to allocate that 90% stock and 10% bond within a portfolio. There are countless ways to do this. Here are a few sample portfolios to help you think about your options:

Portfolio A:  The Two Fund Portfolio

• 90% Total Stock Market 
• 10% Total Bond Market 

With this option, you’re buying two funds, but you’re diversifying across a cross-section of thousands of stocks and bonds. Your diversification is through the roof, and you can add money to these funds knowing that you’re minimizing risk and tracking the broader market.

Portfolio B:  The Three Fund Portfolio

• 60% Domestic Stock 
• 30% International Stock 
• 10% Total Bond Market 

If you want to add another level of diversification, you can invest in stocks outside the United States. There are mixed views on this amongst financial experts. Some people say buying U.S. stocks get you diversification outside the U.S. anyways (e.g., Coca Cola sells in tons of different countries). Others argue that owning non-U.S. companies is positive because you’re buying a wider swath of companies (think companies like Nestle).

In my portfolio, I do have a cross-section of international stock, though I weight more heavily towards domestic stocks.

Portfolio C:  The Five Fund Portfolio

• 40% Large Cap Domestic Stock 
• 20% Small Cap Domestic Stock 
• 20% Developed International Stock
• 10% Emerging Markets Market Stock
• 10% Total Bond Market

If you want to get more complex, you can allocate your domestic portfolio by large-cap vs. small-cap stock or developed vs. emerging markets stock.

In my portfolio, I own a total U.S. stock fund that captures both large-cap and small-cap stocks. I think this is the best solution for most people, as it is less complicated.

I do, however, split my developed international vs. emerging markets allocation (as I am more comfortable overweighting towards developed international). 

Portfolio D:  My Current Portfolio

• 54% Domestic Stock (Mix of Large Cap/Small Cap)
• 20% Developed International Stock
• 7% Emerging Markets Stock
• 10% Bond Market (I weight towards intermediate-term bonds because of interest rate risk)
• 9% Real Estate Investment Trusts

In this portfolio, I am diversified across large and small-cap domestically. I have a roughly 2:1 domestic to international mix and am overweight developed foreign stock. I have a small amount of bond exposure (based on my risk tolerance), which I weight towards intermediate-term bonds. Lastly, I have an added asset class, real estate. Real-estate funds tend to be volatile, but because they are not highly correlated to the stock market, they add a level of diversification to my portfolio.

As you can see, there are countless ways to allocate your investments. For most people, options A and B represent significant diversification while keeping things simple. 

How to Invest in Mutual Funds:  Choosing Individual Funds

When it comes to choosing mutual funds, there are countless individual options. Most brokerage houses offer their own flavor of mutual funds. As an example, Vanguard, Schwab, Fidelity, etc. all have an S&P 500 index fund. 

Do not buy overlapping index funds. For example, don’t buy both a Vanguard S&P 500 fund and a Schwab S&P 500 index fund. You are not diversifying, as these will carry primarily the same underlying basket of stocks. 

The next consideration in choosing funds is which brokerage fund you currently use. For example, if you have an account at Schwab, it may be easier to buy Schwab funds because they waive the trade commissions on their funds.

Next, be sure to check the fund expenses. You’ll see an “expense ratio” listed when you research each mutual fund. For example, Schwab’s S&P 500 index (SWPPX) has an expense ratio of 0.02%. BNY Mellon has an S&P 500 index (PEOPX) that holds essentially the same stocks and will have near-identical performance. Except it charges 0.50%. Don’t buy funds with high expense ratios. Period. 

In general, passively managed index funds from Vanguard, Schwab, and Fidelity get the thumbs up from us for their low fees. While there are other good options out there, these are relatively safe bets.

How to Invest in Mutual Funds:  Building a Portfolio

Tying back to the examples I shared above, here are a few sample portfolios. As is always the case on After School Finance, under no circumstances does the information presented represent a buy, sell or hold recommendation on any security and we recommend you speak to a finance or tax professional prior to making any investment decisions (read our full disclosure).

Portfolio A:  The Two Fund Portfolio

• 90% Total Stock Market (VTI (ETF), SWTSX, or FSKAX)
• 10% Total Bond Market (BND (ETF), SWAGX, or FXNAX)

Portfolio B:  The Three Fund Portfolio

• 60% Domestic Stock (VTI (ETF), SWTSX, or FSKAX)
• 30% International Stock (VXUS (ETF), SWISX, or FTIHX)
• 10% Total Bond Market (BND (ETF), SWAGX, or FXNAX)

Portfolio C:  The Five Fund Portfolio

• 40% Large Cap Domestic Stock (VV (ETF), SWPPX, or FNILX)
• 20% Small Cap Domestic Stock (VB (ETF), SWSSX, or FSSNX)
• 20% Developed International Stock (VEA (ETF), SCHF (ETF), or FSPSX)
• 10% Emerging Markets Market Stock (VWO (ETF), SCHE (ETF), or FPADX)
• 10% Total Bond Market (BND (ETF), SWAGX, or FXNAX)

Portfolio D:  My Current Portfolio

• 54% Domestic Stock (VTI (ETF), SWTSX, or FSKAX)
• 20% Developed International Stock (VEA (ETF), SCHF (ETF), or FSPSX)
• 7% Emerging Markets Stock (VWO (ETF), SCHE (ETF), or FPADX)
• 10% Bond Market (BND (ETF), SWAGX, or FXNAX)
• 9% Real Estate Investment Trusts (VNQ (ETF), SCHH (ETF), or FSRNX)

Again, there are countless combinations of funds, but the above should give you some ideas. 

While there may be some overlap (e.g., an international index may also contain some emerging markets), you should aim to avoid duplication where possible. Avoiding overlap assures you are maximizing diversification benefits. By choosing funds from the same company (i.e., buying all Vanguard funds or all Schwab funds), you may avoid overlap.

Be sure to do your homework on each of the funds to decide if it’s the right fit for you.

A Note on ETFs

You will note in some of the above portfolios, we have identified ETFs rather than mutual funds. 

ETFs are very similar to mutual funds in that they are a basket of stocks. However, ETFs are slightly different in that they trade just like a stock. Mutual funds, instead, have a calculated price. This price calculation takes place at the end of each trading day. 

For now, don’t worry about the differences – the ETFs will serve your needs just as well as the mutual fund options.  

How to Invest in Mutual Funds:  A Summary

You are now ready to start investing in mutual funds. Let’s recap a few key takeaways:

• Aim to diversify away single-stock risk. Mutual funds are baskets of stocks and bonds that help address this need. 
• Avoid actively managed funds; stick to passive (index) funds.
• Choose your portfolio allocation based on your age. We have identified some sample portfolio allocations, but the right allocation will depend on your unique financial situation and risk tolerance.
• Fund expenses will eat your returns; aim to minimize them.
• Allocate across asset classes to further reduce risk. However, for most people, 2-3 well-chosen mutual funds can get you tremendous diversification. Only make it more complicated if you have time to dig into the details. 
• ETFs work very similarly to mutual funds and can provide the same diversification benefits. 

Was this guide helpful to you? Is there anything I missed? Let us know in the comments below!