Basis of Mutual Funds | The ABCs Classes | Fees and Expenses | The Risks of Investing | Advantages of MF | Duties of Mutual Funds | List of Indian Mutual Funds

Selecting a Mutual Fund

Now that you are familiar with the various types of mutual funds, here are some specific guidelines for picking them.

Step 1. Identify the types of funds you need (e. g., growth) to reach your goals.

Getting started will be easier if you first focus your search on a specific type of fund with a specific investing objective. Eventually, your goal should be to build a portfolio that includes both stock and bond funds with various investment objectives and investment styles for maximum diversity. This portfolio allocation process involves assigning appropriate percentages of your total investment portfolio, no matter the size, to interest-earning (income) and stock (growth) investments. You can purchase them gradually, perhaps starting out with a balanced fund, an asset allocation fund, a lifestyle fund, or a broad-based index fund such as a "total stock market" fund. The latter tracks 7,000 + large, medium, and small U. S. companies and is offered by fund families like T. Rowe Price, Vanguard, Fidelity, Charles Schwab, and others.

Step 2. Do more reading.

Visit the library or buy some specialized books on mutual fund investing that will build.

Step 3. Do some research on specific funds.

There are excellent tools to help with the process of narrowing the list. Personal finance magazines publish their "best buy" lists generally twice a year in February and August (e. g., Money, Kiplinger's Personal Finance Magazine, Business Week and Forbes). Barron's and The Wall Street Journal publish a quarterly Mutual Fund Review that reports on all funds' categories and objectives, current and past performances, as well as fee structures. Also, the Investment Company Institute has excellent, free publications on mutual funds. Once you spot several funds that have consistently performed well and are aligned with your goals, go to your library's reference section to complete your research. Rating services such as Morningstar and Value Line Mutual Fund Survey provide current data on mutual funds with a one-page report on each. This makes it easy to review and compare funds you are considering. Look at 3-, 5-, and 10-year periods. Last year's high flyer could be this year's dud.

Step 4. Determine your selection criteria and eliminate funds.

You can whittle down the 12,000 + fund universe to a manageable list in short order by using a few criteria to help with the elimination process. For example, suppose you are looking for a stock fund to invest for retirement. Right there, you have cut the number to a little over 5,000 funds by eliminating all the bond and money market funds. Perhaps you will toss out all funds that have a sales commission, all stock funds with an expense ratio over 1.4%, funds that have an investment minimum over $3,000, any fund where the manager's tenure is less than 5 years, and all funds that have not outperformed 60% of comparable funds over the last 3 and 5 years, etc. Applying these criteria as you research.

Step 5. Call or write for a prospectus.

A prospectus for a mutual fund is the selling document legally required to be distributed to mutual fund investors. It describes the fund's investment strategy as well as the risks and costs of an investment.

Step 6. Make your purchase.

While you can always do business by mail, and in some cases, at a local investment center, most mutual fund groups offer a toll-free number for telephone assistance. Of course, if you are buying a fund with a sales commission, the broker or financial planner executes your order.

Step 7. Continually buy more shares.

One of the best ways to grow your investments is to use a dollar-cost averaging strategy-investing a fixed number of dollars (e. g., $50) in a mutual fund(s) at periodic intervals, usually monthly or quarterly. When the price of the fund is low, your dollars buy more shares. When the fund's NAV moves higher, you will buy fewer shares. Although dollar-cost averaging does not guarantee you a profit, in most cases your average cost per share will be less than the current price.

Picking a mutual fund from among the thousands offered is not easy. Following are some common pitfalls.

1. Prior to investing in a tax-exempt or tax-managed fund, it is best to determine if the tax savings will off-set the possibly lower returns. Additionally, these funds are inappropriate for IRAs and other tax-sheltered account types.
2. Match the term of the investment to the time you expect to keep it invested. Money you may need right away (for example, if your car breaks down) or expect to use soon should generally be in a less volitile fund, such as a money market. Money you will not need until you retire in decades (or for a new born's college education) can reasonably be invested in longer-term, higher-risk investments, such as stock or bond funds. Putting money you will need soon in volatile investments risks having to sell them when the market is low. Investing long term in very stable investments, on the other hand, significantly reduces potential returns.
3. Expenses matter over the long term, and, all other things being equal, cheaper is better. You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio.
4. Several sector funds often make the "best fund" lists each year. However, which sector varies from year to year. Most sectors are vulnerable to industry-wide events that can have a significant impact on your holdings. It is generally best to avoid making these a large part of your portfolio.
5. Closed-end funds often sell at a discount to the value of their holdings. You can sometimes get extra return by buying these, if you are willing to hold the fund until the discount rebounds. Some hedge fund managers use this gambit. This also implies that buying them at the original issue may be a bad idea, since the price will often drop immediately, due to liquidity concerns.
6. Mutual funds often make taxable distributions near the end of the year (semi-annual and quarterly distributions are also fairly common). If you plan to invest money in the fund in a taxable account, check the fund company's website to see when they plan to distribute dividends and capital gains. Investing just before the distribution results in part of your investment being returned to you as taxable without increasing the value of your account.
7. Read the prospectus, even though it may seem boring. It should tell you what risks will be taken with your money, among other vital topics. Check the return and risk of a fund against its peers with similar investment objectives, and against the index most closely associated with it. Be sure to pay attention to performance over both the long-term and the short-term. A fund that gained 50% for a 1-yr. period (which is impressive), but only 10% for the 5-yr. period should raise some suspicion, as that would imply that the returns on four out of those five years were actually very low (if not straight losses) as 10% compounded over 5 years is only 61%.
8. Diversification can reduce risk. Depending on your risk tollerance and how long you will be investing it may be advisable to own some stocks, some bonds, and some cash. For longer-term investments, there may be added reason for some of the stocks to be foreign. You might not get as much diversification as you think if all your funds are with the same management company, since may share research and recommendations. The same is true if you have multiple funds with the same profile or investing strategy; their returns will likely be similar. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher. Buying individual stocks exposes you to company-specific and industry-specific risks, and if you buy a large number of stocks the commissions may cost more than a fund will.
9. The compounding effect is your best friend. A modest return over a long period of time equals a large return overall.

Selecting One or More Mutual Funds

Selecting which mutual funds to invest in is far from easy. More than 8,200 mutual funds are available in today's market, and each fund has a different investment goal and risk level. Finding mutual funds that are right for you means knowing your investment goals, risk tolerance and investing time frame. It also involves researching a wide range of funds so that you understand:

- The fund's investment objective and risks
- The fees, charges and expenses associated with the fund
- Which investments are included in the fund
- How the fund overlaps with or complements your other investments
- Its performance over time (although past performance is no guarantee of future results)

Investors should carefully consider the investment objectives, risks, changes and expenses of an investment company before investing. Your financial consultant can provide you with a prospectus containing this and other important information. Please read the prospectus carefully before investing or sending money.
Investing in mutual funds involves risk. Your principal and investment return in a mutual fund will fluctuate in value. Your investment, when redeemed, may be worth more or less than the original cost.

Basis of Mutual Funds | The ABCs Classes | Fees and Expenses | The Risks of Investing | Advantages of MF | Duties of Mutual Funds | List of Indian Mutual Funds