Through mutual funds, large numbers of smaller investors pool their money to purchase a mixed selection of investment products such as stocks, bonds, cash, and even some types of real estate investments. By sharing a diversified portfolio, mutual fund investors lower their risks and gain access to professional money managers who operate the funds on their behalf. Reputable mutual funds can be excellent investments for the beginner.
Even the best mutual funds have bad years, when shares drop in value. Look at a fund's performance over time (say three years to ten years) to get a sense of its track record. Also check how long the current manager has been running the fund. But remember, past earnings are no guarantee of future results. Here are some things to keep in mind when shopping for a mutual fund.
Fund Prospectus. This is a detailed description of a mutual fund's investment strategy and the specific securities it holds. Read it before buying into the fund.
Fund Type and Strategy. Mutual funds come in many "flavors" reflecting many different investment philosophies. Some are conservative, taking on little risk, while others are more aggressive. Some funds purchase only bonds, others purchase almost all stocks of a particular kind, such as large, blue chip companies, and still others have a variety of investments. Common fund strategies include: "value" investing, which involves buying undervalued investments at low prices; "growth" funds, which purchase stocks of companies expected to grow their revenues or earnings over time; or "income" funds which focus on generating current income through stock dividends or bond yields. The fund's prospectus should provide details on its strategy and fees.
Index Funds. You can buy mutual funds that mimic "market indexes" like the Standard & Poors 500 (commonly called the S&P 500) or other market indexes. The S&P 500 is a list of stocks considered to reflect the overall stock market - so S&P 500 Index fund values usually move up and down as the market does. That usually means a good amount of year-to-year risk, but steady returns over the long term. Because these funds are not actively managed, they usually have very low management fees.
Balanced Funds. Balanced mutual funds buy and manage a diverse mix of investments. These typically have medium levels of returns and risk.
Life Cycle or Target Date Funds. Some mutual funds are managed to adjust risk levels automatically, over time, for investors who expect to retire by a certain date. This could be a good option for some, but check fund fees carefully.
Load and No-Load Funds. Some mutual funds charge an upfront fee for purchasing shares or a back-end fee for selling. These are called "loads." Load funds are generally offered through financial professionals who can help you with investment advice. You can purchase no-load funds (funds that do not charge such fees) directly from the fund companies, if you are ready to invest without getting professional assistance. Since it takes time for a fund to earn back the money it charged you for a load, it generally pays to choose a load fund if you plan to be in it for a long period of time, and if the fund has a strong performance track record. Funds may charge account, exchange or purchase fees; "redemption fees" to discourage frequent selling; or "12b-1" fees to cover fund marketing costs.
Expense Ratio. You and your fellow mutual fund investors share the cost of hiring a fund manager. The fund's total annual expense cost is reported as a percentage, representing the fund's cost compared to the fund's net assets (the value of fund shares at the time when costs are measured). This is the "expense ratio." Typical expense ratios range of 1% to 1.5%, for common types of funds, and can be higher. Even small differences in expense ratios can make a big difference in the amount you can earn on your investment over time. The lower the expense ratio, the more you will keep of your fund's profits.
Arranging for part of your paycheck to be directed into an investment account means not having to worry about making this decision each month. Automate your investment.
Tax Effects. When your mutual fund sells investments to buy others, the fund has to pay taxes on the profits (unless it is part of an IRA or other tax-qualified retirement program). In general, funds that are more heavily managed - meaning the managers are selling and buying more often - tend to be more highly taxed. Check the fund's after-tax return history along with its overall return history. If possible, buy at the beginning of a fund's tax year, so you won't get stuck paying taxes on the fund's profits from the prior year.
Minimum Investments. Mutual funds have minimum initial investments that usually range from $1,000 to $3,000. Some funds have initial investments requirements that are much lower - or far higher. Many have minimums for additional investments. Ask for details.