Choosing the Right Mutual Fund: A Comprehensive Guide for Investors

Over the past few decades, mutual funds have become an increasingly popular investment vehicle. Investors who take part in a company-sponsored retirement plan or who have an individual investment portfolio are often faced with a dizzying choice of funds without understanding the implications for the overall value of their investment. The sobering fact is that most mutual funds underperform the stock market as a whole. Sometimes, investors feel like they could start a mutual fund on their own, but they need to be aware of all that that entails.

Key Takeaways

• Building a mutual fund takes time and experience, but it can provide an investor with lower fees and personal satisfaction.
• Some funds charge investors a load to invest their money with them.
• Beginner investors may want to consider index funds as a low-cost option before venturing out and buying individual stocks or starting a mutual fund.

Understanding Mutual Funds and Loads

Mutual funds are essentially a basket of several, sometimes hundreds, of individual stocks. As a mutual fund investor, you are paying the portfolio manager to buy and sell stocks and/or bonds on your behalf. These investors are passing on their expenses to you in the form of an expense ratio.

Unfortunately, the fees don't stop there. Some funds charge you a 'load' based upon the class of fund shares you purchase. Loads are fees for buying and/or selling funds. The load on a mutual fund is highest if the fund is bought and then sold in the short term.

Typically, fund managers want control over your money for longer periods of time and discourage the trading or hedging of mutual funds. Regardless of whether you are buying a fund for one year or twenty, avoiding funds that have a load will save you dollars. These expenses, albeit disclosed and transparent, can eat into your potential return, particularly over longer investment horizons.

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How to Build Your Own Mutual Fund

Before You Begin

You can start building your own basket of stocks by doing some homework. The investment of your time will save you money in the long run. Besides your time, your only expense is the transaction fee to buy and sell stocks.

Picking good stocks to begin with is critical to avoiding recurring trading expenses. If you have to frequently rebalance your fund, the trading commissions will negatively impact your returns.

Companies such as Wal-Mart (NYSE:WMT), Microsoft (Nasdaq:MSFT), Target (NYSE:TGT), and other icons of American business, can form the basis of a core stock portfolio. If you know very little about stocks, take a class on the fundamentals of investing at a community college, buy a book or two on basic investment choices, or browse the investing tutorials located on this site.

Keep in mind that not all mutual funds are created equal. If you do not have the time or inclination to build your own portfolio, then target mutual funds with an expense ratio of less than 1%.

Staying Ahead

Perhaps the most critical factor in deciding whether a fund is worth your investment dollar is its relative performance – how your prospective new funds compare to the index and its peers. Each fund has a benchmark that it is compared to in performance and expenses. Most common is the Standard & Poor's 500 index, but there are several others that are prominent.

If your fund is underperforming that index and the fund manager is charging you money to underperform, it may be time to move on. Yes, there is some truth to the adage that past performance does not guarantee future results, but you can help optimize future performance by minimizing unnecessary costs such as loads and high-expense ratios. Sites like Morningstar and Lipper present a good picture of relative performance and costs. Simply enter your fund symbol, and relevant data should be readily available for your analysis.

Index Funds

Another option investors should seriously consider is putting money into an index fund, which is a fund strictly correlated with a particular index —say, the Dow Jones or the Nasdaq. These funds do not trade or turn over stocks frequently, therefore expenses are minimal; in addition, these are typically no-load funds. Industry experts credit Jack Bogle and his Vanguard family of funds as being the leaders in low-expense index investing for life.

One of the downsides or inherent risks of investing in index funds is that you are at the mercy of the composition of that index. In other words, if the composition of the S&P 500 or the Dow Jones changes, you are locked into what money managers refer to as a rebalancing effect. Also, many argue persuasively that these indexes are slow to adapt to the overall economy.