Why use mutual funds in the first place? The short answer is to save money and to earn returns that are hopefully higher than those associated with guaranteed investments, such as Certificates of Deposit. Before investing with mutual funds, be sure to know your investment objective, which is the goal and time frame you have to invest. This 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 and preferably more than 10 years.
The reason why most mutual funds usually provide greater returns over time than guaranteed investments is 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 portion or the entire original amount invested.
The greatest risk for you as an investor, however, is likely to be you. Be careful of "chasing performance," which is the human 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. Slow and steady wins the race!
Mutual funds are like baskets of investments because one single mutual fund can invest in dozens or hundreds of stocks and/or bonds, referred to as "holdings." There are many mutual funds that are diverse enough alone to invest a large portion of your hard-earned savings, but it is a good idea to spread your risk (diversify) across the different mutual fund types, such as stock funds, bond funds, and money market funds.
The costs associated with buying and selling mutual funds can be broken into four basic types:
Front Load: These are charged up front (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 and therefore your initial investment will actually be $950.
Back Load: These are charged only when you sell a fund. Also called deferred sales charges, back loads are usually in the 5% range and may decline or even be reduced to zero over time, usually after 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 average around 1.50% ($1.50 for every $100) for stock mutual funds and are for the ongoing management of the fund. Also, sometimes included in the expense ratio is an operational charge, called a 12b-1 fee.
We've all seen the disclaimers about past performance. However, a mutual fund investor will still consider past performance in their initial evaluation before buying. Review longer periods, such as 5 and 10 years, and compare the performance with that of other funds in the same category.
It is also important to see how long the manager has been at the helm of the fund. If, for example, 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 cannot be given credit for that 5-year performance.
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 basic things that every investor should know to be successful in investing in mutual funds.