How do you choose a mutual fund? But first, is it time for you to start investing? You may be asking the question – should invest while you’re still in debt? Or, perhaps – what is enough emergency savings before investing? These can be challenging questions to answer, but in general, you should invest as early as possible in life to maximize growth, especially if you can get a 401(k) match by your employer.
Priorities Before Investments
However, if you’re in debt and have minimal or no savings, you’ll want to work on those goals as a top priority. Only invest up to the point of getting an employer match if you can still make forward progress on these top priorities. Certainly you want to build emergency savings and get out of debt as quickly as possible to avoid missing out on investing and the magic of compounding.
Mutual Fund Investing
Now, assuming it’s the right time for you to invest, let’s talk about investing in mutual funds. Dave Ramsey always suggests buying a good growth stock mutual fund. But, is this advice enough for everyone?
Obviously, you can buy indivdual mutual funds, but most commonly mutual funds are offered as investment choices in your company 401(k) or IRAs. Some people prefer to using a broker or advisor to help them choose mutual funds. However, some more daring individuals who like some excitement prefer to choose funds on their own. Actually, these people, who invest well, invest the time to consider many aspects to mutual fund investing.
If you choose to invest on your own you’re going to be faced with a lot to consider. So, the rest of this post serves to give you a brief overview of some considerations and hopefully, spark your interest in learning more before making what can be a costly investment decision.
Note: I’m not a broker or financial advisor, so I’m far from an expert when it comes to recommending investments or all the ins and outs. These considerations are some things I’ve learned along the way and have found in reading articles, so definitely conduct your own research.
What to Consider in Choosing a Mutual Fund
Your Goals and Risk Tolerance
The first thing you’ll want to do is to evaluate your investment goals. Ask yourself the following questions: How old are you and how long do you have until you retire? What is your risk tolerance? What is your investment objective – growth, income, preservation of assets?
Answers to these questions will help you decide on the right type of fund(s). Certainly, some funds offer more rewards, but have greater risk. Generally, speaking there are equity funds, bond funds and money market funds.
Money market funds are generally safe places to put your money, but don’t offer great rewards. However, as a short-term investment instrument, they will typically offer better returns than a savings account.
If you’re looking for income you might consider bond funds. Bond funds invest primarily in government or corporate debt. However, they aren’t without risk. If interest rates go up bond funds decline in value.
Equity funds invest in corporate stocks with an objective of longer term growth of your investment. You can understand there are many different types of companies, so there are also many types of equity funds based on investment styles and size.
Mutual fund expenses may include management fees, administrative fees, distribution fees and other expenses. Obviously, it’s important to make sure you find funds that keep these costs to a minimum as they can eat into your return over time. Make sure you check the fund prospectus to learn about the fees. According to Motley Fool -
Index funds typically charge about 0.20% of the assets, and actively managed funds currently average about 1.5% per year. The average fee, by the way, has actually been climbing in recent years. Any fund that has fees above 1% per year can be expected to under perform the total returns offered by an index fund.
A sales charge, or mostly commonly known as sales load is a commission you pay to a broker when the broker recommends a mutual fund. You can pay a front-end sales load (when you purchase the fund) or a back-end sales load when you redeem the shares. You may have heard paying sales charges isn’t worth it. I’ve always been given this advice and according to Motley Fool this advice is accurate.
You should be aware that there is no real difference historically between the performance of load funds and no-load funds in terms of year-to-year performance.
As in the past, I’ll continue to avoid funds with a sales loads. Just be careful as I’ve found the whole process of understanding sales charges (and expenses) can be quite confusing.
Just as you’ve probably heard it’s not wise to buy and sell your investments all the time, you don’t want your fund doing the same. You’ll want to know how much your fund is turning over investments each year. Look for funds with a lower turnover percentage. 100% means they sell everything and buy new stocks each year. More turnover usually means more expenses. Just like it costs you to buy and sell, it costs the fund too.
Management of the fund is important. For example, you don’t want a fund manager who is inexperienced. Perhaps a brokerage company is trying to test a new fund manager and review performance. But, why would you want to let them conduct that experiment with your investments? You wouldn’t, so read up about the management, their history and how long they’ve been with the fund. Look at how long they’ve been managing the current fund and if they’re fairly new you may want to consider another investment.
Performance and Volatility
Basically, volatility is when your investment moves up and down. For some mutual funds it can be a roller coaster ride which may not be so much fun for you. It’s common for your investment to fluctuate, but at the same time, according to Forbes, you don’t want to see large swings. You can avoid volatility by diversifying with different types of mutual funds. For individual funds, take a look at the best years and worst years and decide if there is too much fluctuation for your liking. Obviously, a long-term perspective on investing may help lessen the emotions of volatility.
Don’t get hung up on looking at great returns over just a few years. They investments can be the next big thing, but not do so well after 5 years or more. Rather, I like looking at a funds performance over at least a 5 year span of time. 10 years is even better. You can also compare the fund to market indexes such as the S&P 500. Ideally, you want to perform at or better than such an index.
Finally, if you want to do your own investing, you need to study. Read the prospectuses. If you’re going to choose a fund, you need to spend the time to know the information discussed in this post as a good starting point. Sure, mutual fund investing in itself is diversifying which helps reduce risk, but don’t fool yourself. Mutual fund investing still involves a lot of risk, so the best bet is to invest in different types of funds to stay well diversified and get a steady return on your money.
What do you think about these tips? Are there any you would add to the list?
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Last Edited: 9th June 2010