How to Invest in Mutual Funds and Index Funds

Written by Jimmy Atkinson and Andy Hagans. Published November 17, 2015.

Learn the logistics of making a mutual fund investment in this third chapter of our Beginner’s Guide to Mutual Funds.

In this chapter:

How do I buy mutual fund shares?

There are four ways to start investing in mutual funds. Which method or methods are right for you depend on your employment situation, comfort level with managing your investments, and personal preference.

Through a retirement plan offered at work

If your employer offers a 401(k) plan, 403(b) plan, or one of the various other types of tax-advantaged retirement plans, you will likely have the option of investing your account’s assets in mutual funds. Although the selection of mutual funds typically offered through employer-sponsored retirement plans is somewhat limited, it is still a good idea take advantage of these accounts due to their tax benefits (which is illustrated in more detail toward the end of this chapter).

You can get a free PDF version of this report, The Beginner’s Guide to Mutual Funds: Download it here.

For certain types of retirement accounts, your employer will match any contributions you make, up to a certain limit. At the very least, you should fund your retirement account up to this match limit — a free lunch if there ever was one.

Directly through the fund issuer

This may be the simplest way to invest in a mutual fund if you’re a self-directed investor who has already maxed out his retirement account, has no access to a retirement account, or is investing for a shorter time period than a retirement account allows. (Retirement accounts typically penalize any withdrawals made before the account holder turns 59 and one-half years old.)

Purchasing directly through the issuer cuts out the middleman, so there is never a fee (beyond the fund’s expense ratio) for purchasing shares. Whether you purchase directly through the fund issuer or through your own brokerage account is largely a matter of personal preference.

Through a self-directed account at an online broker

While purchasing directly from the fund issuer cuts out all middlemen, purchasing through a brokerage account may be more convenient for some investors. If you’ve decided that you want 100 percent of your investable assets in Vanguard funds, you may be just fine purchasing all of your fund shares directly at Vanguard.com. But if you have (or plan to have) investments in mutual funds across multiple issuers, and maybe a few individual stocks as well, you may wish to consider purchasing everything through one brokerage account, for the simplicity of keeping all of your assets in one centralized place.

But you should be aware of two things when purchasing mutual funds through a brokerage account: 1) there may be a transaction fee to pay on each trade; and 2) some share classes may not be available unless purchased directly. For instance, Vanguard’s Admiral share class of mutual funds has higher investment minimums in exchange for lower expense ratios, but these funds are usually only available for purchase at Vanguard directly.

Through a financial planner

If you would prefer not to take on the responsibility of being a self-directed investor, you can employ a financial advisor or planner to purchase mutual fund shares for you. If you employ a financial advisor, make sure you know how he is compensated. Often times, an investor can incur load fees when purchasing through an advisor.

A load fee is a commission to the advisor, payable upon the purchase of a fund. If you give your advisor $10,000 to invest, and he sells you a mutual fund with a 5 percent load fee, he pockets $500 of your money, and invests only the remaining $9,500. On top of this, he may also be taking a 1 percent annual fee on your assets. Bottom line: think twice before you hire a financial advisor, and if you do, make sure you are completely aware of how he charges you, and how much you are paying in fees.

Do I need a financial advisor to invest in mutual funds, or can I do this myself?

You certainly do not need a financial advisor to invest in mutual funds. Millions of investors capably self direct their mutual fund investments all on their own, without paying for professional help. Often, financial professionals are mere middlemen who are of negative value to the investors whom they purport to serve. Employing a financial advisor can actually devastate your investment returns over time, even with a fee as seemingly small as 1 percent per year, which is what commission-based advisors typically charge.

In the first chapter, we discussed how mutual fund fees can impact the value of your investment over time. Now, let’s look at the negative impact a 1 percent advisor fee can have.

In the above chart, you’ll notice that a $10,000 investment can grow to hundreds of thousands of dollars over a 40-year period. Assuming an annual return of 8 percent, the investor who pays no advisor fees will see his initial investment grow to $242,000 in 40 years. Another investor who pays 1% annually to his financial advisor will finish with $163,000 — missing out on roughly one-third of the value.

That said, the right advisor — particularly a fee-only advisor — can help you avoid making major behavioral mistakes. Whether you choose to invest on your own or with some help from a financial professional is really a matter of personal preference. If you do employ a professional advisor, you should avoid paying annual commissions on your portfolio; instead, opt for a fee-only advisor who charges hourly or monthly.

Should I invest using my 401(k) or IRA account, or should I start a new account?

The answer to this question depends largely on your investment horizon, or how long you are planning on investing before taking withdrawals from the account. If you are saving for a term shorter than the amount of time until your retirement, a new account may be wise. There are often penalties on any withdrawals from retirement accounts before the account holder turns 59 and one-half years of age.

If you do indeed plan on having a long holding period, up to retirement age or beyond, then it would be to your advantage to max out your retirement accounts before opening a taxable account. It is generally best to max out your 401(k) or comparable employer-sponsored retirement plan at least up to the employer contribution match limit, which varies from employer to employer. Not all employers will offer a contribution match on a 401(k) plan, but the tax benefits of this account still make it worthwhile to invest in.

In 2016, the 401(k) and 403(b) contribution limit is $18,000 annually. If you’ve maxed out your 401(k) or 403(b) for the year, the next place to invest for retirement is an IRA. For IRAs, the limit in 2016 is $5,500. If you’re able to max out both of these type of accounts (meaning you’ve been able to set aside over $23,500 for retirement in a single year), then you should open a regular taxable account.

Let’s examine how different the growth rates can be between a tax-deferred account and a taxable account. In the chart below, a 25-year-old investor starts making annual $5,500 contributions (the current IRA maximum) and receives an 8 percent annual return until he turns 65. Assume that he pays a 25 percent tax rate.

After 40 years, the taxable account is worth only 56 percent as much as the tax-deferred account. (It would be disingenuous to avoid noting that in the case of a Traditional IRA, withdrawals are taxed. Assuming the same 25 percent tax rate, that would erode the after-tax value of the tax-deferred account to $1.3 million. But that’s still a lot more than the taxable account.) By now, the importance of maxing out your IRA every year should be quite clear!

You can get a free PDF version of this report, The Beginner’s Guide to Mutual Funds: Download it here.

In the first three chapters, we’ve covered the basics of mutual funds, index funds, and how to invest. In chapter four, you’ll learn how to build a successful portfolio of mutual funds.


← Back to chapter 2 | Continue to chapter 4 →

The Beginner’s Guide to Mutual Funds

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