When it comes to investing, mutual funds are a basic building block. About 44% of U.S. households and 94 million individual investors own mutual funds, according to a 2017 study from the Investment Company Institute (ICI). And they like them â€” more than 8 in 10 mutual fund-owning households believe mutual funds can help them reach their financial goals.
That said, knowing how to choose mutual funds isnâ€™t always a slam dunk. There are some things you should understand before diving in.
A mutual fund is essentially a group of investments that have been put together to achieve a desired kind of return. When you buy a share of a mutual fund, you are buying a small piece of all the investments, so mutual funds are a useful way to diversify without needing to choose (and buy) individual stocks, bonds or other types of securities.
Mutual funds come in a variety of flavors, from those that track an industry, such as health care or energy, to those that track an index, such as the S&P 500 or the Dow Jones Industrial Average. Some are designed with your target retirement date in mind â€” getting more conservative as you get closer to quitting work. Others invest entirely in large or small companies, fixed-income and even international stocks. As of 2017, there were 9,356 mutual funds in the United States, according to the ICI â€” so itâ€™s a wide field.
There are many strategies you can use to select mutual funds for your own portfolio. Knowing these seven key considerations will help you determine the right types of funds to meet your investing goals.
First and foremost, what do you plan to do with the money youâ€™re investing? Is it for retirement? College? A down payment on a house?
Answering this question will help inform the types of mutual funds you would consider. For instance, if youâ€™re saving money for a down payment for a home, you probably wouldnâ€™t invest it in a target-date retirement fund.
How do you feel about losing money? How do you feel about losing a lot of money? â€śEverybody likes to make money, but what happens if, out of nowhere, it just gets ugly?â€ť asked Peter Creedon, a financial planner with Crystal Brook Advisors in Mount Sinai, N.Y.
Whether youâ€™re a younger investor with a lot of time to be aggressive or an investor nearing retirement who needs to be more conservative, there are mutual funds to match both approaches â€” and plenty in the middle. Try this risk tolerance assessment from the University of Missouri to get a better read on where you stand.
Some mutual funds carry a sales load, meaning you must pay a fee to purchase or redeem them. Experts recommend steering toward no-load funds, which are mutual funds without those types of fees, instead. The less you pay on the front end, the more youâ€™ll have available to invest overall. â€śNo-load funds are plentiful, and there are many high-quality options,â€ť said Kristi Sullivan, a financial planner at Sullivan Financial Planning in Denver, Colo.
You also should take note of the expense ratio on a fund, which represents the annual operating costs of running the fund. The lower the expense ratio, the more youâ€™ll take away in earnings.
â€śIf you own a fund where the gross return was 10% during the year and the expense ratio was 2%, then you are only netting 8%,â€ť said Ted Toal, a financial planner with RCS Financial Planning in Annapolis, Md. â€śAnd studies have shown that funds with lower expense ratios tend to have better performance over time than funds with higher expenses.â€ť
Turnover ratio is a measure of how frequently the investments within a mutual fund are bought and sold each year. The higher the ratio, the more often thatâ€™s happening. If youâ€™re investing within a tax-deferred account â€” such as a 401(k) or IRA â€” this measure doesnâ€™t matter, but if youâ€™re investing within a brokerage account, funds with high turnover can bump up your tax bill.
In either case, high turnover can boost transaction costs. â€śAnytime a fund makes a trade, they have to pay commissions on that trade,â€ť Toal said. â€śThe more they trade, the higher the trading costs for the fund, and that subtracts from the return of the investor.â€ť
An actively managed fund means thereâ€™s a fund manager who is actively buying and selling securities based on what they think is best and aiming to outperform the market. Passive management, on the other hand, means a fund is automatically pegged to a benchmark or index, such as the S&P 500.
While it might seem like youâ€™d want someone working for the best result, actively managed funds tend to come with higher fees, and the majority lag behind the market over time, according to research from S&P Global. Passively managed funds, meanwhile, mirror market returns and generally carry lower expense ratios â€” a win-win.
Sure, you can look at how a fund has done in the past, but donâ€™t make your decision based solely on track record. â€śGood past performance could be luck or a skill set that was trending at the right time at the right place,â€ť said Mitchell Kraus, a financial planner at Capital Intelligence Associates in Santa Monica, Calif. â€śItâ€™s very easy to create a portfolio or find funds that have great past performance. The trick is finding funds that will perform well moving into the future.â€ť
If youâ€™re determined to use track record as a metric, compare a mutual fundâ€™s history to that of its peers. â€śToo many clients will see a fund that went up and buy into it, and most of that return was based on being in an asset category that had done well,â€ť Kraus said. â€śThere are funds that underperformed the market as a whole but have overperformed their peers in their asset category, and those are the funds that are important to look for moving forward.â€ť
While itâ€™s acceptable to own funds with a very specific focus â€” technology stocks, for instance, or high-yield bonds â€” itâ€™s not wise to put all your money into a single area of the market.
â€śYou can make as many guesses as you want, but we simply donâ€™t know what is going to perform well in any upcoming year and whatâ€™s going to perform poorly,â€ť Toal said. â€śItâ€™s best to generally own everything so you donâ€™t have to guess. In the long run, you should come out with the average return of the market.â€ť
Mutual fund investing can be a little overwhelming. There are thousands of funds available, youâ€™ve got limited time to research them, and everyone has an opinion about where you should put your money. But if you have done your due diligence, are investing regularly and are diversified, you probably will be in good shape. Just stick with your plan.
â€śWith all the information available today, itâ€™s easy to get distracted and think thereâ€™s something better out there,â€ť Toal said. â€śWhat most people will find is by constantly moving your money, usually youâ€™re going to earn much less over time than if you just pick a good fund, stick with it and keep putting money into it.â€ť
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