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All about how mutual funds work

Find out exactly how mutual funds work and how you can leverage them to make you money.

Ramit Sethi

If you’re new to the world of personal finance, there are a lot of questions that come up that you may be embarrassed to ask.

Such as, “What are stocks and bonds and what do they do?” or “How do I get started saving for retirement?” because society tells us that we should already know about it.

But I’ll be honest…

…I LOVE THESE QUESTIONS!!!!!

If you ask me questions like these, it tells me two things:

  1. That you’re a Top Performer willing to fight invisible scripts that say you might sound dumb if you ask questions like these.
  2. You’re willing to learn more about finance and improve the situation you’re in.

And one subject I always see people struggle with is mutual funds.

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How do mutual funds work?

Is it important that I have one?

What the hell is a mutual fund?

I’m going to answer those questions for you — as well as let you in on which fund I invest in.

I’ll also make fun of stupid things most people do with them. I mean, this is IWT after all.

How do mutual funds work?

Mutual funds pool your money with the money of other investors and invest it in a portfolio of other assets (e.g. stocks, bonds).

By investing alongside other investors, you’ll be able to invest in portfolios that you wouldn’t be able to afford alone.

Mutual funds are typically managed by a fund manager who picks all the investments in the portfolio. This is often a big selling point for beginner investors who don’t have much experience and would rather place their faith in an “expert” in the mutual fund world.

Because these fund managers actively manage your money, you’ll sometimes hear mutual funds referred to as “actively managed funds.” They’ll also charge a variety of fees for their work (which I’ll go into more later).

And if you want to invest in a mutual fund, the mutual fund manager is important. You’re essentially investing in them by putting your money in their fund. They have A LOT of incentive to do a good job for you as their jobs literally depend on how well the funds perform. They also receive bonuses in the millions if they do a good job.

But does that mean that the majority of mutual fund managers are able to beat the market?

I’ll let Luke Skywalker answer that one for you.

NOPE.

According to Dow Jones, 66% of large-cap (big company) mutual fund managers failed to beat the S&P 500 in 2016 (the numbers are even worse for mid- and small-cap managers). And when that same study looked at actively managed mutual fund performance over 15 years (you know, close to the length of time you’d keep your money in to save for retirement) more than 90% fail to beat the market.

So let’s recap:

Pros of mutual funds

  • Mutual funds are very hands off when it comes to investing. This means you don’t have to worry about actively managing your funds on a day-to-day basis.
  • These funds hold many stocks, so if one company tanks in your fund, it all doesn’t go down as well.
  • Mutual funds are an easy way to make a diversified investment.

Cons of mutual funds

  • Many funds charge an expense ratio as well as possible upfront fees in order to be run by an “expert” (the next section explains this more).
  • If you invest in two mutual funds that overlap investments, you’ll get a less diversified portfolio (ex: If you have two funds that both hold Microsoft, and Microsoft implodes, then you get hit twice). You can fix this by getting an index fund that invests in the entire market though.  
  • You’re paying an “expert” to manage your hard-earned money — and they rarely ever beat the market.

If you’re not careful, you might end up investing in a mutual fund that:

  1. Charges you a bunch of fees.
  2. Is managed by someone who could lose you your money.

Boy, I wish there was a way to get all the pros and barely any of the cons. *STROKES BEARD*

The types of mutual funds

Mutual funds are like the different scents at a Yankee Candle store — there are an INSANE amount of different kinds. Each with their own benefits and drawbacks.

You can pick a mutual fund based on a variety of different factors including risk, return, sector, geographic area of investment, and more. For example, you can invest in a fund focused on different energy services, or a fund focused on emerging-markets, or even a fund for medical devices.

These funds tend to fall into even bigger buckets. Each one comes with their own benefits, drawbacks, and stipulations before you can invest in them. Let’s take a look at four of them now:

  1. Money market funds. These are high-quality, short-term (less than one year) investments in securities issued by the government (who issue US Treasury securities like CDs), or corporations (who issue commercial papers). They have the lowest returns because they have the lowest risk.
  2. Bond funds. Otherwise known as fixed income funds. As the name implies, these funds invest and trade different kinds of bonds (investments in the form of debt a company owes to an investor with a fixed interest rate). They typically have higher returns than money market funds but come with more risks since all bond funds are affected by interest rate risks (if rates go up, bond fund value drops).
  3. Equity funds. Also known as “stock funds” because they invest in…well, stocks of many different companies. They come in three different ways: Large-cap (big blue-chip companies like Apple or Google), mid-cap (companies that aren’t behemoths but aren’t start-ups either), and small-cap (smaller companies).
  4. Hybrid funds. These are a mix of stocks, bonds, and other investments. Many of these funds can even invest in other mutual funds. That’s right. It’s mutual funds in mutual funds.

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And there’s actually a fifth type of fund I haven’t gone over yet and it’s the best one.

Can you guess what it is?

Why index funds rock: They avoid these awful mutual fund fees

Index funds are the best type of mutual funds. Period.

Most mutual funds charge a fee called an “expense ratio” (or management expense ratio). This is an annual fee that’s typically around .25% to 2%. It’s paid out through the returns of your fund.

This money goes towards a variety of areas that are mostly BS, including the fund manager, administrative costs, and a distribution fee that’s used to advertise your fund.

Also, when you purchase a mutual fund, you may be asked for a commission called a “sales load” that comes in two forms:

  1. Front-end load. Paying a fee when you purchase a fund.
  2. Back-end load. Paying a fee when you sell the fund.

AVOID BOTH OF THESE.

Instead, you want a “no-load fund.” Why? Loads cut into your profits and there’s zero evidence they produce any results. In fact, no-load funds tend to outperform load funds. Seriously, it’s just silly that anyone goes with them.

So what kind of mutual fund offers no sales loads, low expense ratios, and doesn’t require an active money manager?

(Psst, index funds!)

Index funds: The greatest thing ever

I use index funds, and so should you.

Index funds are a special type of mutual fund that, instead of being actively managed by an “expert,” is tracked using software that matches the stocks in the market. And remember how almost no actively managed mutual funds beat “the market”? Well, an index fund is essentially betting on “the market.”

For example, Charles Schwab has their Schwab S&P 500 Index Fund that has every stock in the actual S&P 500.

How much do you think the expense ratio is?

.03%

That’s it! No front- or back-loading fees, and no money manager who might screw up your investments. Just the opportunity for you to invest directly into the market.

Many brokers such as Schwab also have index funds that invest in an international market as well as the 1,000 largest publicly traded companies in the United States.

Since index funds invest in the entire market, they’ll be less volatile — which means you’ll earn money slower. But if you keep your money in the market over your lifetime, I promise you you’ll make money.

I LOVE index funds — and I’m in good company:

“[Most investors would] be better off in an index fund.” -Peter Lynch

“Just buy the damn index funds.” -John Bogle

“Consistently buy an S&P low-cost index fund. It’s the thing that makes the most sense practically all of the time. Also, I can’t believe I was featured in Forbes right next to Ramit Sethi! Wow!” – Warren Buffett

Okay, the last sentence of the Warren Buffett quote was made up…but the rest is true! There’s a reason index funds are a favorite of financial leaders and thinkers out there. It’s because they WORK.


The S&P 500 since 1950.

So let’s recap. Again.

Pros of index funds

  • With less risk, you stand to make a lot more money with index funds.
  • You save money on dumb costs because index funds don’t have money managers or sales-loading costs. Your expense ratio is also much lower.

Cons of index funds

  • Slower gains in funds.
  • That’s it.

“Okay, I’m sold. How do I get an index fund?”

When it comes to actually purchasing a mutual fund and investing, I suggest two places.

Roth IRA and 401k

Your retirement accounts (Roth IRA and 401k) let you purchase index funds. To do so through your 401k, you’ll have to speak to your company’s HR department in order to set up an investment plan through the mutual fund you want. And, as I’ve written, the S&P 500 index fund is a great place to start.

If you want to invest through your Roth IRA, you’ll have to set it up through a brokerage.

Check out my video below where I suggest a few good ones to help you get started with your Roth IRA.

Banks, credit unions, and stock brokers (oh, my!)

Banks, credit unions, and stock brokers offer avenues to invest in mutual funds. In fact, there are plenty of fantastic brokers that offer a wide variety of mutual funds for you to choose from.

My suggestions:

All of these places offer an excellent variety of index funds to choose from, so you can’t go wrong with them.

Signing up is ludicrously easy. Just follow the 7 step guide I’ve outlined below (the wording and order of the steps will vary from broker to broker but the steps are essentially the same).

NOTE: Make sure you have your social security number, employer address, and bank info (account number and routing number) available when you sign up as they’ll come in handy during the application process.

  • Step 1: Go to the website for the brokerage of your choice.
  • Step 2: Click on the “Open an account” button. Each of the above websites has one.
  • Step 3: Start an application for an “Individual brokerage account.”
  • Step 4: Enter information about yourself — name, address, birth date, employer info, social security.
  • Step 5: Set up an initial deposit by entering in your bank information. Some brokers require you to make a minimum deposit so use a separate bank account in order to deposit money into the brokerage account.
  • Step 6: Wait. The initial transfer will take anywhere from 3 to 7 days to complete. After that, you’ll get a notification via email or phone call telling you you’re ready to invest.
  • Step 7: Log into your brokerage account and start investing!

The application process can be as quick as 15 minutes. In the same time it would take to watch half an episode of Rick and Morty, you can be well on your way to financial success.

If you have any questions about funds or trading, call up the numbers provided above. They’ll connect you with a fiduciary who works for the bank in order to give you the best advice and guidance they can.

Beyond mutual funds

If you want even more actionable tactics to help you manage AND make more money, you’re in luck. I wrote a FREE guide that goes into detail on how you can get started doing just that.

Join the hundreds of thousands of people who have read it and benefitted from it already by entering your information below to receive a PDF copy of the guide.

When you’re done, read it, apply the lessons, and shoot me an email with your successes — I read every email.

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32 Comments

  1. chetan

    Hi Ramit

    Excellent discussion above on index funds. One question is – what if you don’t have enough to meet the min. investment needed to get into more than a few funds (so you want to access different index funds – not just the SP 500) . Say I have 10,000 dollars to invest. I can definitely do VFINX (Vanguard 500), and add one or two more. In contrast we have the fidelity 2040, which is an asset allocation fund. The expense ratio is 0.79, and i did not find any other expenses in the prospectus. The expense ratio is of course way higher than the SP (0.18), but I get more diversifcation. (BTW – it’s interesting to note that if you buy from fidelity, there is an extra 0.16% mgmt fee. I didn’t see that at Ameritrade). Maybe one could invest in the Fidelity 2040 to begin with, and then once we have enough $$ to diversify (and i mean diversify beyond the SP; Will Bernstein, Four Pillars of Investing – pg 272 shows a very diversified portfolio), one can make one’s own portfilio of different index funds. Would appreciate your thoughts on this.
    thanks!
    c

  2. Anonymous

    Hi Ramit
    Mistake in the previous comment – the expense ratio is 0.79%, not 0.79. My bad there. Also, The SP 500 is 0.18%. Pls also ignore the comment on the management fee at fidelity. But given the low expense ratio and the extent of the diversification, it looks very attractive, and SIMPLE.

    thanks
    c

  3. Brandon

    Thanks for this article. It inspired me to actually take a look at the performance and prospectus information of the available investment options in my company’s 401k. Lo-and-behold, found an S&P 500 index fund. After checking out the cost ratio of the mutual funds in the program and then realizing that by using the goal-directed investment model provided, I was probably spending even more than the 1.6-2% cost ratio of the individual funds, decided it was time to take more control of my investment direction and stop being lazy. One of these days I’ll figure out how to get more control of the money in that 401k, but until then at least I can waste less of it on fund managers.

  4. wwsuccess

    Ramit,

    I don’t disagree that index funds are better than 85% of mutual funds. But since the performance of mutual funds is so easy to find, why not invest in the 15% that actually beat the market at a reasonable cost? I have been investing in Selected American Shares for many years and they’ve been beating the market in every time horizon, without charging exorbitant fees.

  5. Ramit Sethi

    Because you don’t know which ones will beat the market until you look backwards in time.

  6. Corey Jewett

    Just in case Ramit’s case wasn’t already convincing enough:
    http://sanfran.com/home/view_story/1507/

  7. Gabriel

    I disagree with you, Funds are a great investment if have a moderate ammount of knowledge. I didn’t see you talk about the risk of the funds (debt vs. stocks), if you study the funds you want to invest in and you know the risk you can tolerate, you can make a pretty good investment. For example I invested in a couple of funds three months ago and I have managed to get a 16% return, already having paid all the operational costs. I think it’s a great way of saving money, if you¡re willing to leave your money in there for 3 to 5 years and spend some time studying the funds you are going to invest in

    • Lindsey

      Hi Gabriel,

      Do you assist people with investing? I would like to ask you some questions via email if you would be willing.

      Thanks,
      Lindsey

  8. blogginginvestor

    Good article. I will now actually look at the performance of index funds in India after reading your article. I was under impression that actively managed mutual funds are the best bet.

  9. Brian

    While index funds are superior to actively managed funds, there is a strange paradox in that the more popular index funds become, the less likely they are to outperform actively managed funds. Index funds work on the premise that the value of all stocks is accurately reflected in their market prices – that there is no advantage to searching for mispriced stocks, something that goes on all the time with actively managed funds. As more money flows into index funds and out of active funds, the chance of finding mispriced stocks in the market increases. Eventually, the more mispricings a fund manager can capitalize on, the more likely he/she is to earn a return in excess of the market return. Bottom line is, index funds work best only when there is more money in actively managed funds.

  10. Reality Bytes

    I am being actively sold on hedge funds. I imagine that index funds will do poorly if the market takes a downturn. So too will Mutuals? I wonder what Ramit’s opinion is?

  11. marvin

    the problem with index fund is you can’t really mimic the index fund. Since all the index fund will try to buy in and buy out at the same time and that’s probably several % right there lost to other mutual fund. Or they have to wait which means they are not true index fund. What’s you take on this? Some financial planners suggested just opposite of what you said here.

  12. rob

    Strangely the vast majority of people are financial illiterate, (basically a pet peeve, the reason our primary education system is so poor is that the worst enemy of a politician is an educated voter, few politicians desire an educated consumer) and trust without verification, and sadly do not want to spend even sixteen hours per year investigating the numbers and what they actually mean, and compare them to the alternatives. They just turn it over to there broker, and let him decide. That is the sole reason the bottom 85% of the mutual funds exist coupled with fads that one can talk about in social settings. Just like all investments, including Mutual Funds (MFs)– Each investment has to be audited periodically. I been quite successful with MFs, my main screen points are: 1) No loads, I always been able to find a equal to or better mutual fund with without a load (excluding 12b-1 fees, which I do try to minimize). This I believe has been widely documented one rarely gets anything for paying a load. 2) Small Mutual funds on total assets, basically it is easier to turn a row boat than a aircraft carrier, and typically the manager more hungry. 3) Low turn over rate. Basically if there is typical above average turnover, in the portfolio that tell me the manager did not do his homework. They are constantly chasing the next fad 4) Pick out the mutual fund families which close to new investors, more purchases of shares from existing investors when they have a superior year, and then everybody want to get into that specific fund. 4) Just like other investments, when it performance is below average for too long of a period for no valid reason – it is time to find a new investment, but find where you going to invest prior to selling. 6) I prefer small companies MF, and mid cap MF, and overseas MF. These investments are typically harder to investigate than large companies. If I invested in large company MF’s then I would consider buying stocks directly; but, probably would use mutual fund literature to select individual small and mid cap companies for both stock and to screen employment opportunities 5) I will probably never get out of MF unless something changes dramatically in that area., The better MF managers visit the plants, talk to the manager’s, talk to the competition, and go to the trade shows etc. That don’t just look at the written data provide by the news services.

  13. Victoria

    Who is a good brick+mortar/online stock investment company if you are interested in investing in ETFs like the S&P 500 and QQQQ?

  14. typome

    Hello Ramit, I was wondering what your thoughts are on ING’s IRA and how they invest in their mutual funds? I normally wouldn’t invest in mutual funds, but I do want to have an IRA. It’s just that ING’s IRA invests in mutual funds and not index funds. Do you think that is okay? Thanks for reading!

  15. jana

    index funds also, at least where i live, have much less marketing/advertising. the actively managed ones use often very clever tactits to persiade you to buy them. probably for a reason.

  16. Lee Smith

    The reason people invest in regular mutual funds instead of index funds is because they just don’t know the difference. There is no press about it or it’s not on the front page of the newspaper.

    Also, most people have a 401k from their job and if it is not offered in there than they will never invest in one. It would be a disadvantage to mutual fund companies to include it in retirement accounts because they would make less money per year on it.

  17. Sameer

    Wonderful discussion… however I still feel consistent performing mutual funds will always outperform markets i.e. index funds. It is always about fund manager and investment policies.

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  21. Kat Cramer

    If you’re family reveals they have a mutual fund for you is it possible to switch the money into an index fund? Also if you are headed to professional school should you let money sit in a mutual fund/ index fund until you make an income and use loans to pay for tuition? Or should you go ahead and start using the money in the fund to pay for tuition? The money does not cover the tuition in full.

  22. Shane

    Good article! I’d like to comment one branding business tip that can “Help you get rich” and get your message to your target audience.

    The internet is the biggest player in the investing game nowadays. Networking, investor outreach, statistics, and most Invest Mutual work are done online. “I will teach you to be rich.com” is way too long of a domain name. A shorter name has countless attributes that I would love to breakdown for you, if you’d like. But for now I will try and keep this short.

    Invest.com sold for $X,XXX,XXX this week…Which makes sense because it is a short keyword term that could be used by many businesses in the financial industry. A name like InvestMutual.com at this point in time is not a $x,xxx,xxx name. It is however a short two keyword domain that could be used by many businesses in the financial industry. As more and more companies buy up exact keyword domains the prices will continue to rise, and the short sweet domains will be for those grand fathered in, or those with big checkbooks.

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    To sum it all up. I think if you are going to teach people how to be successful in the Mutual Investments world you should have a better domain name that is easier to remember, ranked better in google, and is EASIER FOR MORE INVESTMUTUAL (students) to find this site.

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  23. Pascal Pellegrino

    Interresting

  24. David Purnell

    You don’t need a mutual fund to get just $800, which in my opinion is peanuts, for a $10k investment. Moreover, a lot of your profit will go to your “fund manager” and even if you don’t make any profit, you will be charged a “maintenance fee.” I would probably invest in any developing country’s 1 year FD, which also gives you 7-8% returns, and is probably the most safest bang for your buck. They can also be compounded and you can also make some side money if you time the forex markets!!

  25. Future Millionaire

    Thank you for this great blog. If i want to invest in an index, do you recommend a fund or an etf? Thank you in advance

  26. Shuchi

    I hope, just like you read "each" email, you read "all" comments from readers. Has any of your reader ever written you that "I want to know about YOU Ramit"? Yes or no whatever, I am glad if you consider me the first one and serve my curiosity. Thank You!

  27. Samuel

    Ramit, I love it, I agree, but I messed it up!

    Re-reading "I Will Teach You To Be Rich" made me double-check my Roth IRA and—dang it! I ignorantly 1) invested in a lifecycle mutual fund which 2) has a target date 20 years before I intend to "retire"!

    I now have found the correct *index* target date fund, and I will buy into that and start making automatic monthly investments. It has been only 2-3 years that I've owned my "not optimal" Roth IRA, so hopefully I'm still achieving the 85% Solution to my long-term finances.

    My question is… What should I do with the incorrect (no longer actively funded) mutual fund?

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  31. sumit gupta

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