Ready to invest in mutual funds? Heres the step-by-step guide you need

But before you hit the buy button, aligning your unique investment needs with the vast array of mutual funds on the market is essential. A step-by-step approach to investing in mutual funds can help you identify your top financial goals and vet funds with increased confidence.

How to invest in mutual funds

Ready to get started? Follow these steps to buy mutual funds like a savvy investor.

1. Decide on your overall investment goals

When you go camping, you dont want your backpack full of extra weight that doesnt help you get to where youre going. And when you invest, you dont want your portfolio filled with assets that dont help you achieve your financial goals. Thats why naming your goals is an essential first step for any mutual fund investing journey.

Having a plan is important to everyone, but not everyone should have the same plan, says John LaForge, head of real asset strategy for Wells Fargo Investment Institute. For instance, consider two investors saving for retirement, but one is 30 years from retirement, and the other is three yearssame goal, but (hopefully) quite different plans to achieve it. 

LaForge says the real objective for investors at the goal-identifying stage is to understand themselves better. And if youre unsure about your top investment goals, you can explore questions about your financial concerns, your timeline, and finances to help identify them.

• What worries you financially? Whether its paying for a childs college education or having a nest egg to fund your retirement travel dreams, being honest about your financial concerns can help identify your most pressing goals.
• How much time do you have? Each investment goal has a timeline. So knowing whether you need to tap funds in two years or 20 can also help determine the appropriate mutual fund choices.
• Are you concerned about taxes? Knowing whether youll invest in a tax-favored account like an IRA or a taxable brokerage can help guide your mutual fund choices.
• How much cash do you have to invest? Since mutual fund investment minimums can vary, figuring out your available cash can help identify funds that fit your finances.

Once you identify your goals, prioritize them. And as you do, remember that the sooner you begin investing for long-term goals, the better. Over time, the magic of compound interest can boost returns.

2. Choose an investment strategy

With your goals in mind, its time for the next step: deciding how youll achieve them. This step is where your investing preferences come into play.

First, consider how active you want to be in managing your mutual fund investments. Suppose youre more of a set-it-and-forget-it investor who doesnt plan on regular rebalancing. In that case, you might prefer owning one mutual fund that handles everything from asset allocation and diversification to periodic rebalancing for you. On the other hand, if youre a DIYer who loves a more hands-on approach, hand-selecting individual funds for your portfolio may be a better fit.

Next, youll want to consider your risk tolerance and capacitytwo related but different things.

• Risk tolerance is how much youre willing to lose in pursuit of higher returns.
• Risk capacity is how much loss you can afford to take. 

Generally speaking, the longer your time horizonhow long you expect to keep an investment until you need the cashthe more risk you can afford to take. For instance, say you open a 529 account when your child is one year old. If you dont mind some bigger swings in portfolio value since you have plenty of time until you need the funds, youd have a higher risk tolerance and risk capacity.

However, if your child graduates in two years and you cant bear the thought of losing a dime of their college savings, youd have a lower risk tolerance and risk capacity. You can use your risk tolerance and capacity to choose mutual funds that align with the practical and emotional aspects of investing.

Finally, you can use mutual funds to align your investments with your values. Socially-responsible investment (SRI) and environmental, social, and governance (ESG) funds, for instance, can direct your dollars toward funds invested in companies with business practices that make the world a better placefor workers, communities, or the climate. And while these funds typically have higher-than-average expense ratios, these fees typically pay for the funds due diligence process, says Cameron Brandt, director of research at EFPR, a financial data and analytics firm.

SRI and ESG fund managers work to make sure that the companies investors are exposed to are treating workers well, reducing environmental impacts, and offer investors strong financial protections, Brandt says. That work involves frequently checking in with companies and verifying that public personas match day-to-day business practices. And for the right investors, the increased due diligence may justify the higher costs.

3. Compare mutual fund options

Mutual fund types run the gamut, from broad to highly focused and everywhere in between. Understanding the most common types can help identify potential contenders for your portfolio.

Equity funds

Also known as stock funds, these mutual funds invest in companies that fit within the funds investment strategy.

• Geo-centric funds. These funds only invest in stocks from home (domestic) or abroad (international or country-specific). International funds are often broken down into developed markets and emerging markets.
• Market capitalization. Funds can also invest in stocks according to a companys market capitalization. The most well-known categories of market cap funds include large-cap, mid-cap, and small-cap.
• Sector. These funds only invest in companies in particular market sectors. Some examples include healthcare, technology, energy, and utilities.
• Growth stage. Funds can often focus on companies at different stages. For instance, growth companies or more established value companies that invest profits differently.

Fixed-income funds

Fixed-income funds only invest in debt assets like bonds, government securities, or mortgage-backed securities. Theyre often broken out by security duration, such as a fund that only holds 10-year Treasuries. They can also be broken out by asset types, including corporate bond funds and municipal bond funds.

Balanced funds

These mutual funds take a hybrid investment approach and hold both equity and fixed-income investments. Each fund divvies up its investments between the two asset classes differently, like a 70/30 or an 80/20 split between equities and fixed income. These funds can make it easy to match your advisors recommended asset allocation to a single mutual fund that offers that equity-to-fixed-income split.

Commodity funds

From precious metals like gold and silver to agricultural products, commodity funds give investors the ability to invest in raw materials. They can hold assets like stocks and futures contracts and can potentially offer investors increased diversification since commodity performance is often uncorrelated to the broader stock market. 

Alternative asset funds

If youre a fan of real estate or more complex investment strategies, alternative asset funds have you covered. Due to the nature of some investments, theyre often considered higher risk than other fund types.

SRI/ESG funds

These funds invest in companies that meet specific sustainability criteria or those that align with values-based missions, including social and religious causes.

Target date funds

Target date funds are typically designed to mature in a specific year, often aligning with college enrollment or retirement. These funds gradually adjust their asset allocation from higher risk to lower risk as the target date nears.

Index funds

Index funds hold assets in percentages designed to emulate the companies tracked in certain financial indexes. For instance, an S&P 500 index mutual fund would hold a portfolio of stocks designed to emulate the weightings of the S&P 500.

Money market funds

These are really the savings accounts of mutual funds and invest in short-term, highly-secure debt assets like Treasury bills and certificates of deposit. While yields are typically low, theyre considered low-risk.

Active vs. passive funds

Mutual funds also come in two different management styles: active and passive.

From tracking market conditions and determining what to buy and sell, actively managed funds have professional fund managers at the helm. More often than not, managers are backed by analyst and research teams that help parse a broad range of industry data to aid in more informed buying and selling decisionsall in pursuit of meeting or beating investor expectations.

While actively managed funds often come with higher investment fees than their passively managed counterparts, Burns McKinney, a portfolio manager with NFJ Investment group, says that those fees can give investors an edge by taking emotions out of the equation.

Not only does a professional money manager have the time and wherewithal to broadly diversify, but they also take the buy and sell decisions out of the investors hands, says McKinney. Therefore, actively managed funds may be an ideal fit if you want that experience and expertise at the helm.

For investors with a mind toward cost savings, passively managed fundswhich are generally index fundswill offer a better value. These funds only buy and sell to keep asset allocations in line with the index they track. Therefore, they dont need a money manager or team to help make investment decisions, since matching index performance is the goal.

As you compare mutual funds, you should also review fund expenses and fees. A lot of time, expenses can be presented as a small percentage, but they can really add up over time, says Brian Walsh, a certified financial planner with SoFi. 

He notes that expense ratios of 0.05% to 0.15% arent cause for concern, but higher ones might cost you significant returns, especially for long-term investment goals like retirement.

To compare fund fees, Walsh recommends that investors use a free mutual fund comparison tool like FINRAs fund analyzer. Since its a tool offered by a major financial industry regulator, not a bank or mutual funds company, Walsh says investors may find it a more comforting data source. He also points to Morningstar as a highly reliable source for additional mutual fund data such as performance and investment strategy, noting that a decent amount of fund information is available without a subscription.

4. Open an investment account

Its time to transform your research into a portfolio. But to do that, you need to choose where to invest. Luckily, there are plenty of investment account types where you can purchase mutual funds. Here are some common account types where you can buy mutual funds.

Employer-sponsored retirement accounts (like a 401(k) plan)

Personal retirement accounts (like an IRA)

Education savings plans (like a 529 plan)

Taxable investment accounts (like an online brokerage)

If youve already identified mutual funds that youd like to have as part of your portfolio, make sure those funds are available at the custodian where you want to open your account. And suppose youre not investing through an employers retirement planin that case, comparing fees, commissions, and transaction costs from multiple brokerages is important since fees can vary widely and impact your returns over time.

5. Buy shares

Its time to invest. When buying mutual fund shares, you can make a lump-sum purchase or smaller purchases at regular intervals using dollar-cost averaging. Your ideal strategy will likely depend on personal preference, cash flow, and transaction fees.

Dollar-cost averaging might be a better fit if:

• You want to take emotion out of investing and make purchases regardless of share price
• Smaller investments on a regular basis are a better fit for your finances
• You want to spread out your risk over multiple purchases and share prices
• Your brokerage charges transactions fees or commissions

Making a lump-sum investment might be a better fit if:

• Youre investing a windfall like an inheritance or tax refund
• You have a higher risk tolerance and are willing to bet that todays share price will lead to higher returns

Whichever purchasing strategy you choose, these steps will help manage expectations for any transaction where youre buying mutual funds:

1. Check your account balance. Ensure you have the funds available to cover your purchases and any transaction fees your brokerage charges. Youll also want to make sure that your initial purchase matches the funds minimum investment requirements. It helps to have a bit more in your account above the expected purchase price, as mutual fund prices update at the end of the trading dayand that final price is what youll pay for your shares.
2. Place your trade. Enter the ticker for the mutual fund and the number of shares you want to buy. Finalize your purchase and wait for your trade confirmation to ensure your purchase went through.
3. Confirm your dividend reinvestment options. Mutual fund shareholders can opt to reinvest their dividend payouts in the fund through dividend reinvestment programs (DRIPs). DRIPs typically make the most sense if youre investing for longer-term goals. If youre retired or investing for income, you may prefer to have the cash from dividend payouts available for withdrawal. 

6. Track your progress

Buying mutual funds is only half the journey. The other half is tracking your investments. Periodically checking in on your funds can ensure that theyre performing on par with similar funds and allow you to adjust your holdings or strategy as necessary. 

When you assess your funds, you may be tempted to use recent performance as the only measurement for success. However, LaForge of Wells Fargo says that tracking goes beyond how a fund performs at a single moment.

Dont judge a fund by a quarter or a year at a time, he says. Instead, look at larger performance windows, like a 1- to 3-year or 3- to 5-year window. You can also compare your funds performance to its peers, like comparing your balanced fund to other balanced funds. If your holdings are in good shape, carry on. If you want to swap out a fund or add a fund in a new asset class, you can do that as well.

It can also help to consult a financial planner to ensure your investments stay on track. Your employer-sponsored plan or bank might offer no-cost access to an advisor. And if you need to come out-of-pocket for an investment checkup, look for advisors who charge by the hour or offer fixed fees for portfolio reviews. 

The takeaway 

Investing in mutual funds offers a low-cost way to streamline your investments and enjoy a level of diversification that only the uber-wealthy can achieve through individual stocks and bonds. By using a step-by-step process, you can identify your investment goals and build a portfolio of funds that aligns with your time horizon and risk preferences.

As you set out on your mutual fund investment journey, remember these factors:

• Focus on your plan. While you and a friend might both be saving for retirement, youll each expect different things from your investments. Its important to follow your plan for your goals, not someone elses plan for their goals.
• Costs are key. Review brokerage account fees and mutual fund expense ratios before you click buy. Both can have a significant impact on your returns over time.
• You dont have to go it alone. Consulting a financial advisor can help you craft a plan and make adjustments as necessary to keep your goals on track, no matter what the markets might bring.