Choosing mutual fund investments from the thousands of fund
offerings available can be daunting. Here are some steps investment
professionals recommend you consider when selecting
investments.
Assess Your Investment Objectives
When you set out to select a fund, your first task is to
formulate your investment objectives and identify your time frame.
For example, you may plan to buy a new house in three years, to
invest for your children's college education in 15 years, or to
fund your retirement in 30 years.
Generally speaking, the longer your time horizon, the greater
your tolerance for risk. If you have an investment time frame of
more than 10 years, you may take a higher degree of risk and
position yourself for higher earning potential over the long term
by investing more aggressively in growth-oriented stocks. On the
other hand, if you know that you will need the money in less than
five years, you may allocate your portfolio towards more
conservative, income-producing securities such as high-dividend
stocks or short-term bonds.1
Match Your Goals With Funds' Investment Objectives
The next step is to identify the types of mutual funds that
match your investment goals and risk tolerance. With the thousands
of mutual funds now available, you certainly have plenty of options
to choose from, whatever your goals are. Don't be confused by the
seemingly endless differentiation of the mutual fund industry, as
most funds can be assigned to one of a few large groups depending
on the kinds of securities they hold.
Stock funds, for example, might be categorized as broadly
diversified, or sub-grouped according to attributes such as the
size of the companies they focus on. Bond funds might similarly
represent the bond market in aggregate or focus on readily
identifiable bond types such as Treasuries and mortgage bonds. Each
group of funds can be categorized further by risk level, such as
above-average risk, average risk, or below-average risk.
A number of information sources, such as Standard & Poor's,
Morningstar, Lipper Analytical Services, and Value Line are
available online and at most local libraries and can help you
understand mutual fund investment objectives, financial
performance, and risk levels. Standard & Poor's, for instance,
arranges U.S. stock funds into five major groups, providing for
each fund investment style, performance and risk analysis, and an
overall risk-adjusted rating in relation to other funds in the same
category.
Examine Individual Mutual Funds
Once you have identified the fund categories that seem
appropriate to your investment objectives, you will want to take a
close look at individual funds in each of the categories. You can
do this by reviewing the prospectus for each fund, which is
available on the fund provider's website or through your financial
professional. A fund's prospectus describes the fund's investment
objective, types of securities it invests in, and the risks these
investments involve. The prospectus is intended to help you to
understand exactly what you are investing in. A prospectus of an
aggressive growth fund may tell you, for example, that the fund
invests in small and often volatile stocks, that it could use
products such as derivatives to hedge or to maximize investment
returns, and that the fund involves above-average risk. You should
read the prospectus carefully before investing.
Performance over the time frame that you are investing for, with
an appropriate level of risk, is the bottom line. So, when you hunt
for top-performing funds, don't focus on the funds' latest
performance only. Instead, look for funds that consistently provide
above-average investment returns in the same fund category for the
past three, five, and 10 years. Compare the annual percentage
returns of a fund with its major benchmark index over the same
period. For example, compare the performance of diversified stock
funds with the S&P 500 stock index. Note that indices are not
managed and individuals cannot invest directly in an index.
While performance over a period of time is usually an important
factor, it is not the only consideration. Other factors may include
the consistency of fund management, investment policies, and
variability in returns over time. It is also important to remember
that past performance is not a guarantee of future results.
Also understand the fees and expenses that the fund charges
investors, as these amounts may vary widely from one fund to
another. Everything else being equal, lower total fees and expenses
result in higher returns.
Buying Mutual Fund Shares
You can buy mutual fund shares through a broker or directly from
a mutual fund company. To buy funds through a broker, you normally
have to pay a commission. You can usually avoid paying a commission
if you buy a no-load fund directly from a fund company. Finally,
first-time mutual fund investors are often advised to start small,
and all investors can practice diversification to lower
risk.2
