Mutual funds could be a quick and effective way to build your portfolio because they may help you buy into a diverse mix of stocks, bonds and other assets through one purchase. But with more than 9,000 funds in the U.S., figuring out how to pick a mutual fund can feel overwhelming.
Here are a few tips to help you get started.
1. Review Your Investment Goal
Before you start researching different mutual funds, consider reviewing what you hope to accomplish with the investment.
For example, are you looking to generate income for today or for the long term? Will you try to protect your money's value against inflation? Mutual funds generally list their top objectives in a prospectus, which is a document that provides details about the investment. It's important to remember, however, that this investment type cannot guarantee growth, and may instead lose value over time, so your objective may ultimately not be met.
Some investments come with more risk than others, meaning they have a higher chance of a loss. In exchange, higher-risk assets may have a higher long-term potential return than lower-risk assets. Try to keep your risk tolerance in mind as you review the types of assets in the mutual funds you're considering.
The amount of time over which you intend to invest may also inform your long- and short-term risk tolerances, and therefore what mutual fund types you might consider.
2. Consider Performance Benchmarks
A prospectus may also list a mutual fund's historic performance, which shows how much they earned over the past few years. Past performance is not a guarantee of future results, but it may be useful in making an informed decision.
Keep in mind that a fund with the highest return is not necessarily the best performer, and it may be useful to consider the types of assets in the fund, as well as fees and expenses. Consider doing your research on the average annual return of various assets like stocks and bonds, and using this percentage as your baseline when you evaluate previous performance. This may help you put your mutual fund's performance in perspective.
3. Try to Minimize Costs
Sometimes mutual funds charge fees. First, some may charge an upfront fee when you buy into the fund. They also may charge an annual expense ratio, which is a percentage of your portfolio every year, or a back-end fee when you cash out.
To help minimize your costs, you could look for funds that have lower fees. You may want to keep your investment strategy in mind, including how long you plan to invest before cashing out, as this could impact which fund is most cost-effective.
If you plan on buying and selling often, you might consider prioritizing lower front-end and back-end load fees. On the other hand, if you plan on buying and holding for a long time, you might concentrate on a low expense ratio because you may not run into the other fees often.
4. Consider Diversification
Diversification is an investment strategy in which you spread your money over a variety of investment vehicles and industries. The idea is that, while one of your investments could lose money, it's less likely that they will all be hurt by the same factor. For example, a rise in oil prices could potentially hurt car stocks but help oil companies. It's important to remember, though, that diversification cannot guarantee profit or prevent a loss.
If you do choose to diversify your investments, consider reviewing the assets within a particular mutual fund. Some of them may be structurally diversified, but a fund that invests in a 100 different technology stocks is not necessarily diverse because the stocks all fall under one industry. If diversification is a factor in your process for how to choose mutual funds, you may want to double check that a fund has a variety of investments.
5. Check the Management Experience
As you narrow down mutual funds, consider looking up the experience and track records of the managers running your top choices. This may matter more for active funds than for passive or index funds. In an index fund, the manager tries to mirror the exact performance of a certain index. In an active fund, the manager is likely trying to pick investments that will outperform the index.
For example, an index mutual fund manager may try to match the S&P 500 while an active manager is trying to find the best stocks on the S&P 500. Since you are counting on the manager to make profitable decisions in an active fund, you may want to look for a manager with a proven history of doing so. Again, past performance does not guarantee future success, but can be a helpful consideration.
These tips on how to pick a mutual fund may help you make a more informed investment decision. While there's no such thing as a "right" mutual fund for everyone, you may be able to find one that suits your unique situation and financial road map.