Mutual funds might sound like old-fashioned assets, but they’re still prevalent and valuable in today’s investment landscape. If you want instant diversification in a 401(k) account, you’ll likely choose from a selection of mutual funds covering different sectors, strategies or time horizons.
While investors have different goals, those using mutual funds often after the same thing: long-term growth over multiple decades. Keep reading to learn why mutual funds are good tools for long-term growth, how to use them in a retirement plan, and when it's best to buy them (hint: it's now).
Mutual Funds and Long-Term Investing
Mutual funds are ideal for long-term investing because they add instant diversification to a portfolio by holding a basket of different securities. When you buy shares of a mutual fund, you’re really purchasing tiny pieces of the stocks, bonds, or other assets held by the fund. For example, buying a mutual fund that tracks the S&P 500 means owning a small portion of all 500 stocks in the index through a single fund share.
Why invest in mutual funds? Because owning lots of stocks is far less risky than owning only two or three. If a company in the S&P 500 announces bankruptcy, your overall account performance won’t suffer because you have 499 other companies to rely on. Index mutual funds track a specific stock index like the Dow Jones Industrial Average (DJIA) or NASDAQ 100, while actively managed funds employ investment managers to pick securities. Either way, mutual funds allow novice investors to utilize professional insights in their portfolios.
Why Time in the Market Beats Timing the Market
Sometimes, conventional wisdom beats the sharpest and newest of ideas. Many investors have lost their shirts trying to pick the hottest stocks each year in search of outsized profits. Even the best investors struggle to predict day-to-day stock gyrations as the market combines thousands of entities across various sectors and countries, all pulling in their own direction.
Timing the market is exceedingly difficult, so mutual fund investors often prefer long time horizons and patient planning. Instead of actively trading their way to wealth, they sit on their hands and allow compounding to do its work. Since the introduction of its current iteration in 1957, the S&P 500 has gained about 6.4% on an inflation-adjusted average.
Benefits of Early and Consistent Investing
The earlier you start, the more time you’ll give compound interest to build your portfolio. Consider investing in an asset that pays a 5% annual return. If you purchase $1,000 worth of shares this year and earn 5%, you’ll have $1,050. But if you continue earning 5% the following year, you’ll wind up with $1,102.50 because you earn 5% on the new total amount of $1,050 — an extra $2.50 on the $50 of interest you earned the previous year.
An extra $2.50 per year might sound inconsequential, but it's not if you expand the timeline and investment amount. Instead of investing $1,000, what if you invest $7,000 into a retirement account? And instead of two years, your timeline is four decades? Investing early is always beneficial, but it's never too late to start building wealth.
Why It’s Always a Good Time to Invest in Mutual Funds
So, when should you invest in mutual funds? How about right now? Here are a few reasons why it's always a good idea to start early on your investment journey.
The Market Is Resilient
Despite what you might hear in financial media, the market is stronger and more resilient than you think. Some stocks in the major indices, like the DJIA and S&P 500, have been trading for over a century, long before any shares were traded on a computer or smartphone. Public companies like JPMorgan Chase and Company (NYSE: JPM), Colgate-Palmolive Company (NYSE: CL), and Altria Group Inc. (NYSE: MO) have histories dating back over 200 years, far longer than any investor can reasonably set their time horizon. These companies have survived depressions, recessions, wars, pandemics, and all sorts of natural and man-made disasters. This is an excellent fact to remember when you hear an influencer investor or TV talking head claim it's time to dump your portfolio.
Long-Term Focus
Patient mutual fund investors who let their capital compound over multiple decades usually reap great rewards for their commitment. Day-to-day market movements can be random and stressful, so why try to predict them at all?
With long-term goals and a solid financial plan, you can weather any volatility or downturn by simply sticking to the script. Utilizing techniques like dollar-cost averaging (more on that below) and periodic rebalancing prevents emotional investment decision-making. Mutual funds are long-term instruments not meant for frequent trading, so consider a different asset if you’re looking for an aggressive trading strategy.
Flexibility in Investment Amount
Many mutual funds come with a minimum investment amount of $1,000 to $3,000, which can often be waived in certain situations. However, when using mutual funds, you can purchase any dollar amount you wish after that initial investment. You don’t need to buy a full share of a mutual fund like you do stocks or ETFs, and most mutual funds come with a dividend reinvestment program (DRIP), which automatically puts your dividends toward the purchase of new partial shares. This flexibility makes it easy for investors to use strategies like dollar-cost averaging, which we’ll explain more in the following section.
Dollar-Cost Averaging and Mutual Funds
Dollar-cost averaging (DCA) is an investment strategy in which assets are bought at standard intervals, usually in the same quantity. By spreading out asset purchases, investors can reduce volatility and remove emotions from the buying process. DCA is a common strategy amongst retirement savers who use tax-advantaged vehicles like individual retirement accounts (IRAs) and 401(k) accounts.
How DCA Works in Mutual Funds
Say you’re trying to plan for retirement and want to use a conservative strategy for growth over a period of decades. In this scenario, you might decide to max out your Roth IRA using a DCA strategy. You could divide the $7,000 annual contribution limit into 12 increments of $583.33 and buy stocks on the first of each month.
By buying the same amount each month, you’ll maximize your purchases when the market is down and buy fewer shares when stocks are at all-time highs. If the market crashes 30% as it did in March 2020 during COVID, investors using DCA wouldn’t need to panic — they simply plan to buy at a discount the following month.
Benefits of DCA
Not every advisor recommends DCA (some prefer a lump sum strategy), but investing incrementally at standard intervals is an excellent way to start retirement planning. Here are three major benefits of utilizing DCA in mutual fund investing.
- Removes Emotions: Making money decisions is hard. When our financial futures are at stake, it's easy to let the caveman portion of our brains take over and enter fight-or-flight mode. But emotional investing is rarely a good idea. You might pull your money out of the market right as the downturn swings back, missing out on the recovery just because you couldn’t bear the thought of more losses. But if you’re using DCA, you aren’t thinking about timing the market; you’re buying on the way down and on the way back up.
- Don’t Need to Time the Market to Lower Basis: As we’ve mentioned (ad nauseam), timing the market is difficult and often foolhardy. Everyone wants to buy stocks when they’re low, and using DCA guarantees you’ll buy shares during both bull and bear markets. Yes, you’ll purchase shares at all-time highs, but you’ll also buy shares right as a downturn ends.
- Consistent Compounding: By sticking to a DCA plan, you’ll build wealth over time by staying constantly invested, adding to your positions and letting compound interest work its magic. When using DCA, the best time to buy mutual funds was 20 years ago, but the second best time is always right now.
Mutual Funds are Divisified and Designed to Build Wealth Over Time
If you want to make money quickly, check out one of our articles on technical analysis or aggressive trading. Mutual funds aren’t meant as quick trading vehicles; in fact, you can’t even buy them during the open market session. However, these assets are ideal wealth builders for those saving in a retirement account like a 401(k). Mutual funds comprise a large basket of securities, providing diversity and risk reduction over long timelines. That’s why market professionals always recommend investing early and often in retirement accounts. And since no one has invented a time machine yet, the best time to get started (if you haven’t already) is today. It's never a bad idea to contact a financial advisor when implementing a long-term investment plan.
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