What to Know About Mutual Funds

Whether you are an experienced investor or a beginner, you are probably aware that there are thousands of mutual funds to choose from and dozens of details to know. However, there are five fundamentals you should learn so you can be successful when you're considering investing in mutual funds.

Getting Started: Investing With Mutual Funds

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Why use mutual funds in the first place? The short answer is: to save money and try to earn returns that are higher than those associated with very low-risk investments, such as certificates of deposit, savings bonds, or Treasury bills.

Before you invest in mutual funds, be sure to identify your investment objective, which is the goal and time frame you have to invest. That will guide you in choosing the best funds for your purpose. In general, mutual funds are best used for time horizons of more than three years; preferably, you'll hold them for more than 10 years.

Know Your Risk Tolerance

Most mutual funds provide greater returns over time than investments with guaranteed returns due to the risk premium rewarded to investors. This premium comes in the form of higher returns associated with accepting market risk, which is the risk of losing some or all of the amount you invested—called the "principal."

Risk tolerance refers to the amount of risk you are willing to accept in the form of loss of value or principal.

The most significant risks are likely to be your emotions, fear of loss, and desire for quick gains. Be careful of "chasing performance"—the tendency to continuously seek and buy the highest-performing funds while selling the under-performing ones. Remember that investing should not be thrilling; it should be boring. Like the old parable of the tortoise and the hare, slow and steady wins the race.

Diversify Your Portfolio

Mutual funds are like baskets of investments, because one single mutual fund can invest in hundreds of stocks or bonds. There are many mutual funds with enough diversity that you could invest a large portion of your hard-earned savings into one; however, it is a good idea to spread the risks across the different mutual fund types.

Some examples to choose from are stock funds, bond funds, or money market funds. Additionally, you could invest in two stock funds, but it would be essential to ensure that each fund had different holdings. Two separate funds with the same holdings neither diversify your portfolio nor reduce risk.

Know the Fund Loads and Expenses

The costs associated with buying and selling mutual funds can be broken into four basic types:

  • Front Load: These are charged upfront (at the time of purchase) and can be up to 5% or more of the amount invested. For example, if you invest $1,000 with a 5% front load, the load amount will be $50.00; therefore, your initial investment will be $950.
  • Back Load: These are charged only when you sell a fund. Also called "deferred sales charges," back loads can be up to 5% and may even decline or be reduced to zero over five or more years.
  • No Load or Load Waived: As the name implies, this category of fund expense has no front load or back load.
  • Expense Ratio: Not all funds charge loads; however, there are underlying expenses in all mutual funds. Expense ratios can be more than 1% for stock mutual funds and are used for the ongoing management of the fund. Sometimes included in the expense ratio is an operational charge, called a "12b-1 fee," which covers the costs of marketing and selling the mutual fund's shares.

Past Performance Is No Guarantee of Future Results

Everyone has seen the disclaimers about past performance. However, a mutual fund investor will still consider past performance in their initial evaluation before buying. Make sure to review longer periods, such as five and 10 years, and compare the performance with other funds in the same category.

While not a guarantee of returns or success, a fund with a long track record of performance through many market and economic conditions, like recessions or market bubbles, demonstrates good management practices.

It is also essential to see how long the manager has been at the fund's helm. For example, suppose you find a mutual fund with an impressive five-year return, but the manager's time at the fund, called "manager tenure," is only one year. This new manager was not present for that five-year performance. Approach this fund with caution, or put it on your list of funds to watch.