How to pick the best mutual funds: 7 essential tips for beginners

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There are thousands of mutual funds on the market at any given moment. So how exactly do you choose? While it may seem difficult, it doesn’t have to be if you follow the right process.

Mutual funds allow groups of investors to pool their money. A fund 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 whose goals align with your own is vitally important.

Here are seven tips to help you select the best mutual funds for your needs.

1. Consider your investing goals and risk tolerance

With so many mutual funds available, it is inevitable that many of them won’t be the right fit. A mutual fund may be popular, but that doesn’t necessarily mean it is the right one for you. For instance, do you want your money to grow steadily over time with a low level of risk? Do you want the highest potential returns? These are questions you will have to answer for yourself.

You must 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 will need access to 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 level of risk according to how close you are to retirement age.

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? 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.

3. Understand the differences between fund types

While there are thousands of different mutual funds, there are not quite as many types of funds. There are a handful of different types of mutual funds that generally align with different investing goals and objectives. Here are a few examples:

  • Large-cap funds. These funds invest in large, widely held companies with market capitalizations usually worth $10 billion or more.
  • Small-cap funds. These 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, but are considered to be trading at a discount. These companies 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 $100 invested in a mutual fund and it has a 1 percent expense ratio, you’ll be charged a dollar 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 funds was 0.71 percent in 2020. The same report showed that the average for index funds was 0.06 percent. While 0.71 percent may not sound like a high number, if you plug them into a mutual fund fee calculator, you’ll find that it can cost tens of thousands of dollars over a lifetime.

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. In the tech world, this is similar to the concept of redundancy, where the failure of one part won’t take the whole system down.

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 diverse is one of the most effective ways to ensure long-term performance and stability. This is one of the main reasons for the appeal of total-stock market funds, which own tiny pieces of every publicly-traded company. There are sometimes crises that can affect an entire industry, so investing in every industry helps mitigate that 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

Yes, you can lose money in mutual funds. As the saying goes, “past performance does not guarantee future results.” It is precisely for this reason that 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.

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 growth.

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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.