Read time: 4 to 5 minutes
Investing might seem complicated. But it’s not so hard. We’ll walk you through everything you need to know, from what a mutual fund is to how you can learn to invest with confidence.
The basics of mutual funds
Understanding stocks and bonds
Stocks and bonds are the building blocks of a long-term investment strategy. Most mutual funds invest in stocks, bonds, or both. But what are they, exactly?
Stocks represent ownership in a company
When you own stock, either directly or through a mutual fund, you are part owner of the company issuing that stock.
It may not get you a parking spot with your name at company headquarters, but ownership does have its privileges. If the company makes a profit, you’re entitled to your fair share.
Mutual fund managers buy and sell hundreds and thousands of shares of stock within the fund each day. When they sell a stock for more than they paid, the mutual fund makes money. Of course, when they sell stocks for less than they paid, the fund loses money.
Bonds are IOUs
If stockholders are owners, then bondholders are lenders.
When a company or government wants to borrow, it issues bonds. Bond buyers are lending them money.
Have you heard the expression, "My word is my bond"? A bond is a legal contract to repay the amount borrowed, plus interest, over a specified period of time.
Mutual fund managers buy and sell bonds too. When bonds increase in value or pay interest, the fund makes money. Of course, when bonds lose value or fail to repay the debt on time, the fund loses money.
What to consider when choosing an investment
Before you choose an investment, take a moment to think about your situation and your goals. Some things to keep in mind:
- Your comfort with risk. Some investments are aggressive. Others are conservative. Find an investment with the level of risk you’re comfortable with.
- Your time horizon. When will you need the money? If you’ll need it soon, you may want to choose an investment with less chance for a sudden drop, since you’ll have less time to recover.
- Cost. A lower-cost fund allows more money to work for you. A fund’s costs are subtracted directly from its returns. So every dollar spent on a fund’s management costs is one less dollar to earn a return.
And here’s a tip: When shopping for mutual funds, don’t just look at past performance. Sometimes the one that performed well last year will fall behind the next. That’s especially true if the fund focused on a small portion of the market that’s done well (and may be due for a fall).
Want to dig deeper? Check out this article on how to choose investments.
The most common investment
Target-date investments have become the most popular investment choice in retirement plans administered by Vanguard.
In fact, 81% of Vanguard retirement plan participants whose plans offer target-date investments invest in one (as of December 31, 2021).* That’s four out of five people!
A target-date fund combines a variety of stocks and bonds into one fund. The number in the fund’s name represents the year an investor might retire. The ratio of stocks to bonds is determined by the year in the fund name. For example, a target-date fund with a year far into the future may have more stocks than bonds in its mix, because the fund has a longer time horizon to manage the risks associated with stocks. As the date in the fund’s name gets closer, the fund manager will gradually shift the fund’s focus from more risky to less risky investments. That way, there’s less chance of a big loss before an investor might retire.
Target-date investments are subject to the risks of their underlying funds. The year in the investment name refers to the approximate year (the target date) when an investor would retire and leave the workforce. The investment will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. Target-date investments are not guaranteed at any time, including on or after the target date.
A secret of successful investors
Even a small increase in your saving rate could result in a surprisingly large increase in your retirement account balance over time and—more importantly—how much money you’ll have in retirement.
For example, say Julie joins her retirement plan today. Whether she chooses to save 3%, 6%, or 12% of her pay will make a big difference in 20 years.
Save too little, and you might not be able to retire when you planned. Save too much, and you may be able to afford to retire early.
Bond funds are made up of IOUs, primarily from companies or governments. These funds risk losing value if the debt isn’t repaid on time. Also, bond prices can drop when interest rates rise or the issuer’s reputation suffers.