How to Pick Good Mutual Funds

11 Tips That Will Save You Time, Money and Heartache

••• Photo: Elke Hesser/Getty Images

So you've decided you need to invest, and that mutual funds are the way to go. How do you pick the best ones? Here are 11 tips to guide you through the process.

  1. Before you select a mutual fund, you've got to know what your investment goals are.  Are you saving for retirement? That means you can afford to be patient, and hold funds through bull markets and bear markets. Are you saving for down payment on a new home? That means you may need the cash in a few years, and must be more cautious. 
  2. Make sure that funds fit your investing habits. For example, if you want to take advantage of daily ups and downs in the market, you can't use funds as they only trade at the end of the day. Furthermore, funds perform based on the skill of their managers, not necessarily the companies bought. Make sure you understand the advantages of mutual funds versus stocks.
  1. Use funds that increase your diversification. Having more funds doesn't always increase diversification. Many funds own the same stocks. Check each fund's major stock holdings to make sure they don't overlap.
  2. Only choose funds that fit within your asset allocation strategy. For example, in the early phase of a business cycle, small cap companies traditionally do best. You might pick ten of the best performing funds, but if they are all small cap, then you will suffer more losses when large cap does better in later phases.
  1. Be alert to mutual fund fees, which can reduce your returns anywhere from 0.5 percent to 8.5 percent. Fees are sneaky. Front-load fees are deducted right off the top, while back-load fees are deducted if you withdraw your investment within the first five years (typically). Most funds have management expense fees, expense fees, and 12b-1 fees. Some experts say only pick no-load funds and those with an expense ratio below 1 percent.
  2. Now that you know what type of funds you need, how do identify the best within those categories? Remember, you are betting on the expertise of fund managers, so you've got to follow their performance. You are really looking for a manager that can outperform the market. In this case, that means the specific index related to that type of fund. For example, a small cap fund must outperform the Russell 2000, not the Dow. Studies show that two-thirds of all actively-managed funds do worse than their benchmark indexes. Therefore, choose fund managers that have been around for at least five years.
  1. Pay attention to the fund company. High-quality firms, such as American, Vanguard, T.Rowe Price and Dodge &Cox, can afford to hire the best managers and treat them well so they stick around.
  2. Will the funds be in a tax-deferred portfolio, such as a 401(k), IRA or Roth IRA? Then you don't have to worry about turnover. That's how much of the fund is sold and turned-over into new stocks. If your fund is subject to capital gains taxes, stay with funds that have a 50% or lower turnover ratio. Otherwise, you'll get taxed on the gains of stocks sold, even if the overall value of the fund drops during the year.
  1. First, you can do it yourself with Morningstar. They have all the information and a handy little rating system that helps pick the best performers. 
  2. Let's say you've looked at Morningstar, and are overwhelmed with the choices. The next step is to pick a good financial advisor. Let them select the mutual fund. 
  3. "Past performance is no guarantee of future success." You'll hear this everywhere, but what does it mean to you? It's simply a statement that says looking at how well a fund did in the past doesn't mean it will do the same in the future. There's plenty of research that shows 99 percent of funds that outperform the market in one decade fall to the average the following decade.