10 Considerations for Choosing Mutual Funds

10 consideratons for choosing a mutual fund graphic

Mutual funds can be a great choice for investing. They offer a number of advantages over other types of investments and are a popular choice for retirement planning. When it comes to choosing the right mutual funds, it can be difficult navigating all of the choices available. There are thousands of mutual funds to pick from and company retirement plans likely only have a limited amount of these available for selection. How do you choose the right mix of mutual funds when you are investing?

There are a few options when it comes to picking mutual funds. You can either hire a professional advisor to hopefully make the selections that are right for you or make selections on your own. There is no right or wrong choice. It ultimately will depend on what you are most comfortable with. If choosing your own mutual funds seems intimidating, it doesn’t have to be. Following some simple guidelines and taking the time to learn about investing in mutual funds is all you really need to take on the task.

What are Some Good Guidelines to Follow When Choosing Mutual Funds?

1. What are your goals and what is the intended purpose to invest in mutual funds?

Investing of any kind should always start with a plan in mind. There will always be ups and downs in the market and sometimes there could even be long periods of these. It is important to know how the investment will be used. Planning for retirement that might be 20 years in the future is much different than investing for a child’s education that might be 5 years in the future.

Typically, investing in mutual funds should not be a short-term investment. If the money intended to be used for investing in mutual funds needs to be in cash for emergencies or used at some point soon, then leave it in cash. With fund expenses, possible sales charges and market swings, it does not make sense to invest in mutual funds for the short-term.

2. Risk Tolerance

How will you be able to tolerate swings in the market and prices of a mutual fund going up and down? Risk tolerance is an important aspect to consider when investing. If you are someone that is not comfortable with showing a loss for any period time, you will want to invest in something conservative. Someone that has a long-time horizon to invest might be more comfortable with a more aggressive mutual fund. You should always keep an eye on your investments. However, if you are someone that would be watching them each day and worried about ups and downs, risk tolerance is a big deciding factor on what type of mutual funds are chosen.

3. No-Load Mutual Funds

There are different types of charges when buying mutual funds. A loaded one has a sales charge while no-load mutual funds do not have a sales charge. This does not mean there will not be any further fees once a mutual fund is purchased, but there is no up-front sales cost to purchase one. I am personally a big proponent of no-load mutual funds. This allows the money you invest to work faster. With a mutual fund that has a sales load charge, it could be something like 5% up front. Someone that invests $10,000 would then only have $9,500 dollars invested with a 5% sales charge.

The issue with sales charges is they can be excessive. If you go the route of getting professional financial advice, an advisor is going to want to charge something for their time. This will either be in the form of a sales charge or as a percentage of overall assets managed. The advisor may not get the entire sales load with part of it going down the chain to the brokerage firm. Yet, they will get paid a hefty fee for selling certain funds.

There are some people that would argue sales loads are not all that bad. This is a personal opinion, but I believe for just picking mutual funds yourself then no-load funds are the route to go.

4. Invest in an Index Fund

Index mutual funds can be a great choice for investing when the investment has ten or more years to grow. Index funds invest in an index, such as the S&P 500 or the Dow Jones. It is estimated that over 80% of fund managers fail to beat the market within a 15-year period. If most of the fund managers are not beating the market anyway, why not just purchase an index mutual fund? These have the advantage of lower turnover rates compared to other mutual funds. As a result, they will often have low expense ratios. By lowering the expenses there is more money in a fund for it to grow.

Investing in an index mutual fund may not be exciting, but it does have a number of advantages compared to purchasing other mutual funds.

5. Do Not Buy Mutual Funds with High Turnover

High turnover mutual funds are ones that buy and sell a large percentage of a portfolio each year. When there is more turnover and trading within a mutual fund the fees and expenses can really start to add up. Taxes in a high turnover mutual fund can also hinder the return rates unless the money is only invested in a tax-free retirement account.

6. Don’t Purchase High Expense Ratio Mutual Funds

Mutual funds and honestly just about any type of financial investment could be comparable to a pyramid scheme. Everyone wants to get their hands in the cookie jar for a small cut of the money invested. There is nothing wrong with this, but some funds do have excessive expenses and it is important to not purchase one that will take away from its returns. High fees can hold the growth back in a mutual fund.

Low expenses in a mutual fund might be something like 0.75% or lower. Index funds that have a low turnover should have a low expense ratio such as this because they are passively managed. High turnover mutual funds that are actively managed could have an expense as high as 1.5%. If you decide to purchase a mutual fund with a high expense, it better be beating the index it could be compared to and then some to make up for the expense you would be paying.

One thing to keep in mind is that a low fee does not necessarily equate to a good mutual fund. I am sure there are some with higher fees that might be quite good. However, don’t purchase a mutual fund just because it has a low expense ratio. The expense should just be one component to consider when purchasing a mutual fund.

7. Dollar Cost Average

Because there are market ups and downs, dollar cost averaging in a mutual fund can reduce investment risk over a long period of time by lowering the overall price paid. The idea with dollar cost averaging is mutual fund units will be purchased at varying prices as the market moves up and down. The average price for the number of units purchased will be lower than the highest price paid.

Dollar cost averaging is great for investors that want to invest in a mutual fund at intervals. Investing $50 or $100 dollars a month will purchase more or fewer units of a mutual fund depending on the time period of the purchase.

Dollar cost averaging is a good strategy for investing in mutual funds. However, it is not perfect. With a market that is on a continual rise, it will not be as effective. For this reason, dollar cost averaging is really best for a mutual fund that has a long-time horizon.

8. Do Not Buy Based on Star Ratings Alone

Companies, such as Morningstar, offer mutual fund reports that give them a star rating. A fund that has a 5-star rating does not necessarily make it a good one. Star ratings are based on past performance. The problem with this is that the economy changes. There are a lot of good funds with just 3 stars.

If you use a star rating to judge how good a mutual fund will do, this should not be the only indicator. The turnover rate and expenses should also be taken into account as well as past performance. Personally, I would not pay too much attention to a star rating and look more at the other variables that can make up a good mutual fund.

9. Look for an Experienced Manager

When choosing a mutual fund an experienced fund manager that has been managing it for some time is a good sign. Within the financial industry, if you are not performing, you will not last long. A fund manager that has been consistent on delivering positive results will have some longevity. This shows that either they know what they are doing or have been lucky in doing it. Either way, an experienced fund manager is good to have.

Sometimes it can be easy to identify if a fund manager has had longevity and will do a good job. This can be done by just looking at a mutual fund report. However, sometimes there might be a fund manager that does not appear to have been at the job very long. If the fund looks promising, dig a little deeper in its history. Often a new fund manager may have been under a very experienced one for some time. They are likely to have been mentored by someone very experienced having a successful track record. A new fund manager that has a history of this might be a good choice.

10. Mutual Fund Performance

Past performance is not always an indication of the future. But a mutual fund that has a good performance history has a much better chance of doing well. Look for ones that have a history of at minimum ten years. If you find a mutual fund that does not have ten years of performance, then the fund has not been around that long. Ten years of performance is good to see because there are usually many ups and downs within that period and you can see how it performed. Performance over a short time is not a good indicator of how well a mutual fund might do.

The performance of the mutual fund should be beating similar ones that are in the same category. Also, look to see if the fund is consistently beating a comparable index. If it is coming up short year after year and the expenses are higher than an index fund, it is probably not a good choice for an investment.

Final Word

Selecting mutual funds for investing does not have to be complicated. There are thousands to choose from with some being better than others. Taking the time to learn about them can help with making an informed decision. This list should not be all comprehensive on how to choose a mutual fund. It is only intended to provide some general best practices when looking to invest in them.

Whether you hire a professional financial advisor or decide to invest on your own it is important to have some good general knowledge on investing in mutual funds. This will help with understanding if a financial professional is offering you the best investment for your goals and the possibility for a good return.

Compared to other investments mutual funds can be a good choice for reaching financial goals, such as saving for retirement or college education. If you are not familiar with mutual fund investing, you should take the time to learn as much as you can about the basics at a minimum. Chances are you will need to make some of your own investment choices at some point in time or at least have an idea of what is being offered is good for you.

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