How to pick the best mutual funds: 7 essential tips for beginners
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Key takeaways
- With mutual funds, investors can buy a diversified portfolio without an investment advisor, which makes a well-constructed portfolio more accessible.
- There are thousands of mutual funds to choose from, but not all of them will be a good fit. Consider your investing goals and risk tolerance before buying.
- Mutual funds with strong performance records and experienced fund managers can help maximize long-term portfolio growth and minimize shorter-term risk.
There are thousands of mutual funds on the market at any given moment. So how exactly do you choose? While choosing a mutual fund may seem difficult, it doesn’t have to be.
Mutual funds allow groups of investors to pool their money, and the fund’s manager then selects investments that align with the fund’s investment strategy. As a result, the individual investors who buy shares in the fund are actually investing in those assets selected by the fund manager. Because of this, finding a mutual fund that aligns with your goals is vitally important.
That’s just one of many factors in deciding which mutual funds are right for you.
7 essential tips to pick the best mutual funds
Here are some tips to help you select the best mutual funds for your needs.
1. Consider your investing goals and risk tolerance
There are many, many mutual funds. Just because a mutual fund is popular doesn’t mean it’s the right fund for you. It may be helpful to ask yourself some questions: Do you want your money to grow steadily over time with a low level of risk? Do you want the highest potential returns? Questions like this can help you start to determine which fund is right for you.
Also consider your risk tolerance. For instance, are you willing to tolerate large swings in your portfolio’s value for the chance of greater long-term returns? If you are investing for retirement, it’s typically best to keep your money invested for the long haul.
But if a very aggressive strategy will cause you to get cold feet and sell your investments, it’s best to adjust your strategy to something more suited to your risk tolerance. After all, selling your investments may also result in missing out on returns. Plus, you may realize capital gains and incur tax obligations depending on the type of investment account.
Your time horizon is also important. If you need to access your money in less than five years, an aggressive growth fund is likely not the best strategy. One example of a fund that has the time horizon already built in is a target-date fund, which adjusts its risk level based on how close you are to retirement age.
Often, investors with a long time horizon and a high risk tolerance will generally earn higher returns by investing in all-stock mutual funds because they can afford to take on more risk over time. Those who need some degree of safety, and are nearing retirement for example, will likely want to turn to mutual funds that have more exposure to bonds or other fixed income investments.
2. Know the fund’s management style: Is it active or passive?
Another way that mutual funds can vary is their management style. One of the largest contrasts can be seen when comparing active and passive funds. With actively managed funds, the fund manager buys and sells securities, often with a goal of beating a benchmark index, such as the S&P 500 or Russell 2000. Fund managers spend many hours researching companies and their fundamentals, economic trends and other factors in an attempt to eke out higher performance.
The tradeoff with actively managed funds is that fees can be high to compensate fund managers for their time. Are those fees worth paying given your overall financial situation and goals? That can seem difficult to answer, but if you consider the fund’s past performance compared to the market, that can bring some perspective. You should also see how volatile the fund has been in addition to its turnover.
Over time, passive funds tend to outperform active funds, especially once fees are factored in.
3. Understand the differences between fund types
While there are thousands of different mutual funds, they come in only a relatively few different types of funds specializing in a few segments of the market. Here are some examples:
- Large-cap funds
- Large-cap funds invest in large, widely held companies with market capitalizations usually worth $10 billion or more.
- Small-cap funds
- Small-cap funds tend to invest in companies with market capitalizations between $300 million and $2 billion.
- Value funds
- Value funds consist of stocks that are perceived to be undervalued. These are typically well-established companies that are seen as trading at a discount. These businesses may very well have low price-to-earnings or price-to-sales ratios.
- Growth funds
- Growth funds largely invest in companies that are rapidly growing, and whose primary objective tends to be capital appreciation. They may have a high price-to-earnings ratio and have greater potential for long-term capital appreciation.
- Income funds
- Some funds pay regular income. This can come in the form of a dividend or interest, such as with dividend stocks and bond funds.
4. Look out for high fees
It’s important to be conscious of fees because they can greatly impact your investment returns. Some funds have front-end load fees, charged when you buy shares, and some have back-end load fees, charged when you sell your shares. Other funds are no-load funds; as you might expect, these funds have no load fees.
But load fees are not the only type of fee. The other fee that garners much attention is the expense ratio. These fees are usually charged annually as a percentage of assets under management. Thus, if you have $10,000 invested in a mutual fund and it has a 1 percent expense ratio, you’ll be charged $100 per year. With the advent of index funds and increased competition, we are increasingly seeing mutual funds with very low expense ratios and a handful of mutual funds with no expense ratio at all.
According to a recent Investment Company Institute report, the average expense ratio for actively managed equity funds was 0.65 percent in 2023, down from 0.66 percent in 2022. The same report showed that the average for index funds was 0.05 percent. While 0.65 percent may not sound like a high number, if you plug it into a mutual fund fee calculator, you’ll find that it can cost tens of thousands of dollars over a lifetime.
You can also help keep costs low by working with one of the best brokers for mutual funds.
5. Do your research and evaluate past performance
It’s important to do your research before investing your hard-earned cash in a mutual fund. In addition to determining whether a fund aligns with your investing goals, you should also assess the overall quality of the fund.
For example, does the fund have a strong management team with a long history of success? The most successful funds have created well-oiled machines that don’t necessarily rely on a single person to continue running smoothly.
It’s also important to watch out for high levels of turnover. This occurs when the fund manager buys and sells securities frequently. The main reason this is an issue is because it creates taxable events. That isn’t a problem if your funds are held in a tax-advantaged account, such as a 401(k) or IRA. But for taxable accounts, high levels of turnover could hurt your returns significantly.
These questions will bring context to the overall performance of the fund. Also check the fund’s historical performance. Does it typically beat its benchmark? Is the fund unusually volatile? This will help you know what to expect should you choose to invest.
6. Remember to diversify your portfolio
Keeping your portfolio diversified is one of the most effective ways to ensure long-term outperformance and stability. Total stock market funds, which own tiny pieces of every publicly traded company, have an appeal for exactly that reason: All-encompassing funds can add diversity to your portfolio. Sometimes a crisis can affect an entire industry, so spreading out your money across sectors mitigates this risk.
You can also choose to invest in international funds, bonds, real estate, fixed income funds and plenty of other types of assets. All of these can create a more well-rounded portfolio with lower volatility.
7. Stay focused on long-term growth
As the saying goes, “past performance does not guarantee future results” — and mutual funds are no exception. That’s why you should do your research and consider meeting with a financial advisor where appropriate.
That being said, if you do your due diligence and maintain a well-balanced and diversified portfolio, you can be confident in its potential to grow over time. As we can see with the past 100 years of performance of the Dow Jones Industrial Average (DJIA), the index has been on an upward trend throughout its history. The longest downturn spanned from about 1966 until 1982. While that is a long period of time, the DJIA sharply rebounded, rising consistently for about the next 17 years, despite short-term fluctuations.
This illustrates the importance of investing for the long term. While you can certainly lose money in a mutual fund, investing in funds with strong historical performance and experienced fund managers will help minimize the risk in the short run and maximize your chances of long-term portfolio growth.
Need expert guidance when it comes to managing your investments or planning for retirement?
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FAQs about picking mutual funds
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Whether a mutual fund is good for you will come down to your individual goals. However, there are some funds that perform better than others. Research the fund’s objectives, performance history (by comparing the fund to its benchmark), management and fees. All of these will help you determine if a fund is a good fit for your portfolio.
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Some of the best mutual funds for beginning investors track indexes, such as the Nasdaq 100. Index funds — either mutual or exchange-traded — come with very low fees or sometimes even no fee at all. These low costs help investors keep more of their returns for themselves and are a solid way to start building wealth.
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To sell shares of a mutual fund, you place a sell order directly through the brokerage or fund company. The shares are sold based on its net asset value (NAV), which is calculated at the end of the trading day.
Bottom line
Not every mutual fund will fit every investor’s individual needs. Take the time to assess your long-term goals, risk tolerance and time horizon. Also, learn about how each fund operates. Is it actively managed or passively managed? What segments of the market is it targeting? Overall, stay focused on your portfolio’s long-term growth and invest in mutual funds that have a strong historical performance and experienced fund managers.
— Bankrate’s Logan Moore contributed to an update of this article.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.