Step 4. Pick an investment strategy
For most investors, the next big question will be: Do you want to pay a portfolio manager to pick market-beating stocks? Or are you happy with returns that match the market?
Mutual funds that try to beat the market are known as “active.” They employ a fund manager (and sometimes whole teams of them) to study individual companies, poring over research reports, meeting with CEOs and more, in order to suss out which ones will outgrow rivals. However, all this research is expensive, and active funds charge annual investment fees of 0.6% on average, according to fund researcher Morningstar, or $60 of every $10,000 invested.
In contrast to this, “passive” funds take a more hands off approach. They aim to merely deliver returns that match market benchmarks like the S&P 500, composed of the market’s 500 most valuable stocks, or the Russell 3000, which targets the 3,000 largest. Because passive funds don’t spend money on research, they tend to be a lot cheaper, with the average cost just 0.12% of your invested assets per year—or $12 of every $10,000 invested.
Counterintuitively, passive funds’ low fees mean they usually outperform active funds, despite their efforts to beat the market. Of the nearly 3,000 active funds Morningstar analyzed earlier this year, only 43% outperformed their average passive peers in 2022.
Step 5. Research mutual-fund companies
There are many different companies that offer mutual funds. If you have a 401(k), you’ll invest via your plan’s menu of fund companies. But if not, you’ll have to decide on the companies yourself.
Many of the company names will likely be familiar to you, like Vanguard or Fidelity. If you know you like the funds offered by those firms, you might want to consider opening an investment account directly with the fund company. These companies also offer ETFs, which are similar to mutual funds but can be traded throughout the day like a stock.
“If you’re an investor starting from scratch, you probably want to stick with a larger and more well-known finance company that hasn’t had a lot of regulatory issues,” says Amy Arnott, a portfolio strategist at Morningstar. You can find any regulatory issues a company has by looking at SEC filings, which should be available on the fund company website.
Three of the largest mutual-fund companies are:
Vanguard Group
One of the largest retirement plan providers in the U.S., Vanguard offers accounts like 401(k)s and IRAs, and a plethora of funds of various types and sizes. The firm’s late founder, John Bogle is known for popularizing the index fund and today the firm enjoys something of a cult following among investors, not unlike Apple with tech fans. Here are some of Buy Side from WSJ’s favorite Vanguard mutual funds and ETFs.
Fidelity Investments
Fidelity is another giant in the investing world, although traditionally known for its active funds more than passive ones. Today the company offers plenty of both, as well as those that focus on certain industries such as healthcare and tech, plus fixed-income funds and more. Fidelity’s wide slate of mutual funds, as well as tools to help you trade stocks and other investments, make it Buy Side from WSJ’s pick for best stock online stockbroker.
American Funds
While Vanguard and Fidelity are the Target and Walmart of the mutual fund world, American Funds, which is owned by Capital Group, is something more like its Crate and Barrel. It’s a major player, but more or less focused on mutual funds, as opposed to being a financial everything store.
Capital Group’s actively managed growth-and-income funds, for example, invest in stocks of dividend-paying companies and those that have strong earnings growth potential. The balanced funds, meanwhile, have a combination of stocks, bonds and cash equivalents.
Step 6. Research mutual funds
Once you’ve picked a fund provider, it’s time to study its menu of options. At first glance this can be intimidating, since fund companies often offer dozens of choices, and it can be hard to tell one from the next.
Keep in mind, that’s because many investors like to break the stock and bond markets into small pieces then mix and match. Once you decide what kind of fund you want (say, a passive fund that mimics the broad U.S. stock market or an active fund that targets international stocks) the choices shrink and it gets easier.
Fund screeners—online tools that help you sort and search for funds—that investment companies provide should be a big help. That said, there are some key features to keep in mind.
Fund fees
A fund’s fees are often its biggest determiner of success. As a result, one of your first moves should be to check out these costs, which are typically quoted as a percentage of your overall investment, a figure known as an expense ratio.
Given the average expense ratio for an active fund is 0.6% and for a passively managed one it’s 0.12%, Morningstar’s Arnott recommends looking for funds with fees at those levels or lower.
Fund returns
You can easily find a fund’s historical performance record on the fund’s website or via a research firm like Morningstar. The Securities and Exchange Commission has strict rules about how this information is presented, so this information should always be up to date and apples to apples.
Still, one pitfall Arnott says investors fall into is looking at past performance over the last 12 months or three to five years instead of looking at its performance during a variety of market environments. “Certain investment styles may go in and out of favor,” she says. “So that’s another good reason to try to look at performance over the longest period that you can.”
Step 7. Open an investing account
After you’ve decided on which mutual funds you’re going to invest in and determined a strategy that aligns with your goals, it’s time to open an account and start buying.
How to open a 401(k)
In order to open a traditional 401(k), you’ll need to have an employer who offers one in its benefits package. If you do, they may automatically enroll you; otherwise contact H.R.
You’ll also need to decide what percentage of your paycheck will automatically go into your 401(k) each month. If you are auto enrolled, it’s common to start at 3%.
Some financial planners will recommend contributing as much as 15% to 20% of your paycheck—though if this doesn’t seem feasible, start smaller and try to increase your percentage each year. If you have an employer match, you’ll want to invest at least enough to receive the maximum contribution from your company so you’re not leaving any money on the table.
How to open a taxable discount brokerage account or IRA
To open a taxable brokerage account or IRA, you’ll first need to decide which brokerage company you are going to use. Once you’ve done that, start by filling out an application with basic information, such as your Social Security number and date of birth. You may also be asked questions about your investing experience or employment.
If you like one particular mutual fund or fund firm, it may make sense to open an account with that company as some will charge you a fee for investing in off-platform funds. For example, if you’re a fan of Fidelity’s many funds, consider opting for a Fidelity account.
How to work with a robo advisor
For investors who want a more hands-off approach to investing, a robo advisor could be the best option. Robo advisors are digital, automated services that choose investments for you based on your goals, risk tolerance and personal financial situation. You’ll answer a questionnaire with information about what type of investor you are, get a suggested asset mix and fund your account.
Robo advisors became popular about 15 years ago and there are now many options. Betterment and Wealthfront are among our picks for best robo advisor.
How to work with a financial advisor
If you prefer to work with a human, you may want to find a financial advisor. These professionals can guide you in everything from saving for a down payment to investing for your retirement.
Some financial advisors charge an annual fee or an hourly rate. Others earn commissions when they sell you a mutual fund. These commissions, known as loads, are additional mutual fund fees that are often 3% to 5% of the amount you invest.
Consumer advocates generally recommend favoring advisors who charge fees, rather than commissions. While the details are complicated, fee-based advisors are generally required to be “fiduciaries,” which means they are required to act in clients’ best financial interests. By contrast advisors that earn sales loads or other commissions are, in the eyes of regulators, more akin to salespeople.
Step 8. Buy mutual fund shares
Now that you’ve solidified your strategy and done your research, you are almost ready to buy mutual funds. But there are a few mechanics to keep in mind.
How to buy mutual fund shares
Some mutual funds require an investment minimum, often between $500 and $3,000, but not all do.
Mutual funds may also have several different share classes. While conventions vary, look for the ones called “investor” shares or something similar. A-, B- and C-Shares tend to have built-in fees meant to compensate financial advisors. While R-shares, which are often the lowest-cost shares available, are meant for retirement plans.
Mutual funds only allow investors to buy in once per day at the price when the market closes at 4 p.m. EST. You can place your order for shares before that time, but your trade will generally be executed at that day’s closing price. If you place your order after the market closes, it won’t be filled until 4 p.m. EST the next day. That’s different from ETFs, which have prices that fluctuate throughout the trading day.
How to buy ETF shares
If you want to buy ETF shares, the process is just like buying a stock: You can execute a trade via your brokerage account at any time during the trading day.
You’ll have to indicate how many shares you want to buy. However, you can usually purchase fractional shares instead of whole ones, which means you can indicate the amount of money you want to invest instead.
You’ll also have to decide between a market order, which will execute your trade as soon as possible at the current market price, or limit order, which means you’ll have to set a maximum or minimum the price has to hit to trigger your trade.
Step 9. Be a good long-term investor
An important part of investing in mutual funds is learning how to be a successful long-term investor.
Don’t try to time the market—even when the ups and downs have you nervous. Buying and selling based on fear means you risk missing out on a market’s climb over long periods—which can cost you.
Consider this: A $10,000 investment in the S&P 500 between January 1, 2003 and Dec. 30, 2022 would have grown to nearly $65,000, but missing the 10 best days of the market would cut that return in half, according to J.P. Morgan Asset Management’s Guide to Retirement.
Step 10. Don’t forget about taxes
The taxes you incur investing in mutual funds are similar to those you incur investing directly in stocks and bonds, with a few wrinkles. At the end of each year, your mutual-fund company should send you a Form 1099 that includes details of your potential tax liability.
Capital gains
If you buy mutual fund shares, watch them appreciate in value and then sell them, you may owe taxes on your capital gain. Unlike with other assets, however, you may owe capital-gains taxes even before you sell your mutual fund shares.
That’s because mutual funds themselves trade stocks and bonds, realizing their own profits, ultimately on your behalf. Uncle Sam requires that the fund pass out, or distribute, these capital gains to you, and requires you to report them as taxable, even though you haven’t sold your fund shares. Active funds are far more likely to pass out capital gains than index funds, since they tend to buy and sell securities more often.
Dividends
Just like stocks, mutual fund shares pay dividends. Stock mutual funds typically pass along dividends they receive from the stocks they own. Just like with stocks, you can elect to have these reinvested automatically, but they are still taxable in the year they are paid out. If they are qualified dividends you will be taxed at the lower capital-gains tax rate.
If you own a bond mutual fund, the fund will collect interest from the bonds it owns and pay it out regularly to fundholders in the form of dividends. One thing to keep in mind: While the income will be delivered to you in the form of a dividend, to the IRS it is still bond interest. That means you can expect to pay regular income-tax rates, rather than lower capital-gains rates.
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