Investing in mutual funds is a popular strategy for wealth building because it’s relatively easy to do, while adding a level of diversity to a portfolio. They are also very efficient for adding more shares to your existing investment, because you can often buy more shares without incurring additional transaction fee. Many investors, both beginners and seasoned veterans, use mutual funds in their portfolios.
Adding mutual funds to your portfolio can help you accomplish your financial goals. Here are some things to keep in mind as you invest in mutual funds:
1. Understand Your Financial/Investment Goals
Before you add mutual funds to your investment portfolio, you should have a solid idea of what you want to accomplish. Are you look for growth? Are you hoping to add an element of safety to your portfolio? Do you want regular income?
Your investment strategy should be dictated by your overall goals for your portfolio. The funds you choose should be based on what you hope will happen with your portfolio.
2. Compare Fees
Fees can erode your real investment returns. While you will always pay fees no matter what you invest in, it’s important to limit the fees you pay. Choosing funds with lower fees can help you keep more of your money.
Avoid mutual funds with sales loads. Additionally, consider investing in mutual funds that aren’t actively managed.
- An actively managed fund might charge 2% or more each year.
- An index mutual fund, on the other hand, usually has an expense ratio of less than 1% — and frequently charges 0.5% or less.
Reducing your fees can make your mutual fund investment a little more efficient.
3. Consider Where You Will Hold Your Mutual Funds
Don’t forget to think about the best type of account for your mutual funds. Many investors like to hold income funds in a tax-advantaged retirement account, for example:
- Holding your dividend-paying mutual fund in a Roth account means that you won’t have to pay taxes on your earnings later.
- Bond mutual funds that are comprised of municipal securities, though, can be held in a taxable retirement account without incurring federal tax costs, since municipal bonds aren’t taxed at the federal level.
Also, be aware of other tax consequences associated with mutual funds. In some cases, mutual fund turnover can lead to taxable gains during the year. You should receive a statement from your broker helping you understand the consequences associated with changes in your mutual fund.
Consider the type of fund you have, and then hold it in an appropriate account that can help you maximize your tax efficiency.
4. Use Dollar Cost Averaging
If you don’t have a lot of financial resources right now, investing in mutual funds can be a great way to get started. You can use dollar cost averaging to buy partial funds, and do so consistently. With dollar cost averaging, you invest the same amount of money each month to purchase shares in a mutual fund. If the price drops, you get more shares for your dollar. (The flip side, though, is that you get fewer shares for your dollar if the price rises.)
Over time, a dollar cost averaging strategy can help you build up your portfolio. The point of dollar cost averaging is to get you started — and help you take advantage of consistency in your investing. Use this approach with dollar cost averaging, and you can see good results in the long term.
5. Understand What You Are Investing In
It’s vital that you understand what you are investing in. Before you invest in a mutual fund, make sure you know how mutual funds work, and that you understand the investments involved. If you invest in a bond fund, you should have an idea of how bonds work. If you invest in a mutual fund that focuses on a particular stock sector, you should have an understanding of the fundamentals that influence performance in that sector.
Make sure you have an idea of what your mutual fund investment entails before you make your selection.
Investing in mutual funds can be a smart way to build wealth. However, you shouldn’t approach any investment without first giving it some thought, and without doing a little research.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own blog at Miranda Marquit.