Picking a Mutual Fund

Picking a mutual fund that is right for you is best determined by asking yourself the following questions:

What type (or types) of mutual funds should you invest in? By types of mutual funds we mean the size of the investments--such as giant caps, large caps, mid caps, small caps and micro caps--as well as the category of investments:

This decision should be based on your age and stage of life, the types of investment vehicles you need to diversify your portfolio, and your personal risk tolerance.

Which specific fund (or funds) in a category should you choose to invest in? Choosing a specific fund to invest your dollars into should be based on several factors. The first factor to consider is the fund's performance. Many investors use the net asset value (NAV) per share (the fund's total assets divided by the number of outstanding shares).

However, a much better method is to look at a fund's total return. Total return is a fund's dividends and capital gains distributions as well as changes in a fund's price measured over a certain time frame, ranging anywhere from a year to ten years. You should also take into account a fund's average annual return (the average returns over a certain number of years) to determine a fund's performance. The best-case scenario for a fund is to have performed well in the short-term as well as the long-term. You should compare a fund's performance to other funds of the same type.

If you're happy with a fund's performance, you should check the length of time a manager has been with a fund and whether there is high turnover in a fund's management. Why is this important? If a fund's management changes, the methodology it uses to achieve its objective can change as well and may not be as successful or one that you're comfortable with.

Planning Note Some funds have managers that base a fund's investments on the manager's hunch or market timing. For example, where it's possible, a manager might decide to buy bonds for the fund and sell its stock holdings if he or she senses that the stock market is on a downward spiral. These switches can affect both the size of the fund's investments, as well as the types of investments. While a manager's role is always important, it is even more so for these types of mutual funds than it is for funds that maintain a somewhat constant asset allocation and ride out the ups and downs of the markets.

Where do you get all this and even more information about mutual funds? You should always check a fund's prospectus, an invaluable tool for learning about a fund, and its past, present and future. Much can be learned about a mutual fund's objective and investment style, whether they are growth, income or some combination of the two.

You can also go to websites such as Morningstar.com, which offer an independent analysis of mutual funds and their performance. Subscribing to independent newsletters can also provide a lot of analytical information about mutual funds as well as offer recommendations to investors.

Warning At this point, you might be wondering why you need to choose a mutual fund at all. After all, isn't that what you pay financial advisors for? There's nothing wrong with taking advice from a professional, such as your financial advisor, accountant, or broker. However, even if you hire a fee-only financial advisor who isn't pushing any specific investments or particular funds, we all have our own ingrained preferences and biases. You may totally trust your financial advisor or broker, but you should still always do your own research on his or her investment recommendations. The stakes are simply too high for you to blindly follow anyone's advice. And remember, you can use all the investment formulas for your age and stage of life to figure out the investments you should be making, but no one knows you better than you know yourself.

Dollar-cost averaging. Once you have identified the mutual funds you feel meet your investment criteria, you may want to consider dollar-cost averaging as a method of investing. What is dollar-cost averaging? Dollar-cost averaging is investing a specific amount of money by buying a specific mutual fund or stock on a regular schedule (usually monthly). A good example of a type of dollar-cost averaging is when you contribute to a 401(k) retirement plan with money withheld from your paycheck every two weeks.

What are the benefits of dollar-cost averaging? The benefits are twofold. First is the purpose of dollar-cost averaging and that is to benefit from the inevitable market fluctuations in securities. Every investor's wish is to buy low and sell high, but this is extremely difficult to achieve on a consistent basis and over a long period of time. Even if you choose your investments wisely, market fluctuations can and almost always do affect your investments to some extent. Dollar-cost averaging is a method of evening out the highs and lows of your investments. How successful this method is depends on the performance of the investment.

Another benefit of dollar-cost averaging is that it can enable you to stay the course when it comes to your investment plan. Rather than coming up with a lump sum that you invest all at once, you can stick to a schedule of regular investments in a security that you've decided is a good choice for meeting your financial goals. Dollar-cost averaging is especially beneficial if you feel you may lack the discipline to invest on a consistent basis or if trying to buy low and sell high doesn't fit your personal risk comfort zone.

On the other hand, the disadvantage of dollar-cost averaging is that you don't have the option of determining whether you should invest in a security based on whether it's at a high or low price. If the price of a security goes up without any price decreases, the advantage of dollar-cost averaging is lost. The possibility of this result and the lack of your input into the investment decision-making process once the initial investment choice is made may be beyond the personal risk level you can tolerate.

If you do decide to use dollar-cost averaging for investing, please don't make the mistake of ignoring your security's performance. You may find that, for whatever reason, the mutual fund or stock you chose isn't meeting your investment goals and that you need to make changes.

What are the costs involved with a particular mutual fund? The costs and fees associated with mutual funds can vary, depending on the type of fund and how it is purchased. These fees and costs can have a negative effect on your investment return from a mutual fund. You will want to be sure you are fully informed as to buying, selling, transferring fees and any other costs you may incur if you invest in a specific fund.

© 2024 Wolters Kluwer. All Rights Reserved.