What are mutual funds and why do I need one?
Inflation is around 2% per year, and as you may have noticed if you’ve been following the news, may clock in at above 6% this year. Meanwhile, the maximum interest rate a typical savings account at a bank will earn you is around 1%. So let’s say you put $100 in your savings account. You make 1% interest on it, so you now have $101. You made $1 - but inflation was 2% for the year and that $100 is now only worth $98 - so you lost $2. Overall, your savings lost $1 in value ($100-$2+$1=$99). So keeping your money as cash or in a regular savings account actually loses you money!
What should you do instead? Well, one option is online savings accounts: online banks like Ally offer high-yield savings accounts, which currently carry an interest rate of 0.50% (for comparison, most other bank accounts will currently give you a 0.01% return on your savings).
Pros: just as safe as any other savings account, don’t lose money to inflation
Cons: online bank so no physical locations, still very low interest rates
For long-term savings (at least 3-5 years, the longer the better), mutual funds are an excellent low-risk option. A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments, and other assets. To simplify: a mutual fund is an investment that is a collection of smaller investments, most often a mixture of stocks and bonds. Think of it like each investment is a toy, and the mutual fund is a box. You can put toys of all types in the box and fill it up whatever way you want. Based on how long you plan to keep the money invested and how much risk you desire, you can make your mutual fund however risky suits your tastes. On average, mutual funds have earned about a 6-9% yearly return on investment.
Pros: Diversified, so very low risk of losing money. The longer your time horizon (time between when you invest and when you plan to pull out the money), the lower the risk. Investments are passive - AKA managed by financial professionals with no work required on your part - just deposit money into your account like you would with a savings account. The safest way to receive the highest return on your money. If properly diversified, you should only expect to lose money when the entire market is down.
Cons: You may need to pay fees on your account (can be very low, get into that next). Money is less liquid (may take longer to withdraw/access your money). Depending on the type of mutual fund, you may have to pay fees if you want to withdraw money early.
Some of my recommendations for mutual fund providers:
Vanguard Target Retirement Funds
https://investor.vanguard.com/mutual-funds/target-retirement/#/
Minimum: $1,000. Expense ratio: around 0.11%
Set the approximate year you want to retire (2065, 2070, 2075, …) and Vanguard chooses the right portfolio for you. Very low fees.
Fidelity Freedom Index Fund
Minimum: $0. Expense ratio: around 0.12%
Again, just choose a target retirement year and let Fidelity do the work.
Schwab Target Index Fund
https://www.schwab.com/mutual-funds/types/target-date-mutual-funds
Minimum: $100. Expense ratio: around 0.08%.
Same as above - choose your target date for when you’ll want to pull out these funds, and Schwab will determine your investment mix.
A general rule in investing is that the more risk you’re willing to take, the higher returns that are possible. However, I wouldn’t recommend anything past a mutual fund or index fund to anyone who doesn’t want to sit down and learn about investing and finance. If you’re interested in more personal investing, or trading, check out this map by fellow Menti writer Masada Hutabarat.
Mutual funds often exist within IRAs – these are ‘tax shelters’ that can save you additional money. When you invest money in a mutual fund, you’ll often create an IRA that holds that mutual fund and your invested money. See Masada’s advice for more details. For convenience, here’s a quick breakdown:
Two main types:
Traditional IRA: if your income is low enough, you get a tax deduction based on how much you contributed to your IRA. You pay taxes on this money when you take it out in the future.
Roth IRA: your contributions are taxed in the year you make them. Don’t have to pay taxes on this money when you take it out in the future.
Which one should you choose?
Simple rule: if you have a high income, contribute to the traditional. If you have a low income, contribute to the Roth. Opening an IRA is simple and easy. Usually, it is part of the guided process done through Vanguard/Fidelity/Schwab when you open a mutual fund.
One last note: I am not a financial advisor, and every person’s financial situation is unique. So make sure to consider your own needs and risk tolerance carefully before making any commitments, and consult with others.