Mutual funds provide a way to invest in many assets by pooling your money with other investors. Instead of researching and buying many individual assets yourself, you can buy into a mutual fund to diversify your investments.
But with thousands of mutual funds on the market, how do you select a fund that's best for you? Follow these six steps to pick the right mutual funds for your goals, plus compare a fund's goals, fees and returns.
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1. Set Your Goals
To pick the best mutual fund for you, you need to start with knowing what you want out of your investment. For example, are you investing for the long-term goal of retirement? Or do you have a shorter-term goal in mind (like paying for a home addition in a few years)?
Knowing your goals can help you select the best funds for your investment strategy and risk tolerance. Some mutual funds invest primarily for growth, while others invest primarily for preserving wealth and providing predictable income.
2. Consider Passive vs. Active Funds
Mutual funds can be categorized as actively managed or passively managed.
- Actively managed mutual funds have a portfolio manager who takes an active approach to selecting assets, actively rebalancing the fund to meet objectives. These funds typically aim to outperform the market. That said, you can't predict whether you'll actually see higher returns than the market overall in a given period.
- Passively managed funds don't attempt to beat the market. Instead, they're designed to match market growth, often by tracking a given stock market index, such as the S&P 500.
Both active and passive funds have their own pros and cons. For example, passively managed funds often have lower fees because they require less hands-on work from the fund manager.
3. Review Types of Mutual Funds
In general, mutual funds can be classified based on the goals they set and the assets in which they invest. Here are some of the main types of mutual funds to know:
- Equity funds: Also known as stock mutual funds, equity funds are mutual funds that invest primarily in stocks. They can be a good choice for investors who are comfortable with risk and are after high overall returns.
- Bond funds: These are mutual funds that invest widely in bonds. Like individual bonds, bond funds can help you generate some income and take on less risk than other types of mutual funds. Bond funds invest in specific types of bonds, such as government bonds, corporate bonds or municipal bonds.
- Money market funds: Sometimes simply called "money funds," money market funds are low-risk funds that invest in safe, liquid assets. You can expect to see low returns compared to other types of mutual funds, but their low risk can make them a good alternative to savings accounts for housing money you may need soon.
- Index funds: Index funds are a type of mutual fund that tracks a given market index in an effort to match market growth. To meet its investing goal, the fund assembles a portfolio of stocks and bonds of the companies in a given index.
- Target-date funds: Target-date funds are a type of mutual fund designed to invest for a given retirement date. For example, someone who expects to retire in 2050 could invest in a "Target Retirement 2050 Fund." These funds are designed to invest in a blend of stocks and bonds, gradually shifting to take on less and less risk as the target date approaches.
- Balanced funds: Also called asset allocation funds, these are funds that invest in a blended portfolio of stocks and bonds. They can be a way to balance growing long-term wealth and generating short-term income.
4. Hone in on Specific Funds
Once you have a sense of what type of mutual fund you want to invest in, you can dive into comparing individual funds that align with your goals.
At this stage, it can be helpful to take advantage of tools from trusted financial companies to hone in on individual funds. For example, Fidelity offers a fund screener search tool that provides information on thousands of mutual funds and allows you to narrow your search based on criteria such as risk level and asset allocation.
5. Review the Fund's Prospectus
When you're evaluating whether a mutual fund is a good fit for you, don't overlook the fund's prospectus. The prospectus is a document containing important information about a mutual fund, such as its fees (more on these below) and past performance.
Here are some important pieces of information you'll find in a mutual fund's prospectus:
- Risks of investing in the fund
- The fund's goals
- The fund's strategy
- The fund's past performance
It's important to keep in mind that historical performance doesn't guarantee future results; it's possible for a mutual fund to do very well in one year, then take a dip the next. But there are a few things you should look closely at when selecting a fund.
Look at past performance to see how drastically a fund tends to swing up or down, year to year. This can't help you predict future returns, but it can give you a sense of how volatile it's been.
If you're looking for steady, slow investment income, you wouldn't want to put your money in a fund with a history of marked volatility. On the other hand, if you're investing for a distant goal, such as retirement, you have more time to ride out these highs and lows in pursuit of greater long-term growth.
Turnover rate is the frequency at which a fund buys and sells assets. For investors, a higher turnover rate can mean more taxable events and higher trading costs.
That said, if you're investing in a tax-advantaged retirement account, such as a traditional 401(k) or IRA, your taxes are deferred until you begin taking distributions when you retire (though you may pay higher costs on actively managed funds that trade frequently).
How long has the mutual fund been around? If you're considering investing in a newer mutual fund, keep in mind that you'll have less past data to go off of. A short-term history of wild success may tell you less than a long-term history of gradual growth.
Again, past performance doesn't indicate future returns. But you should be especially cautious about giving too much weight to the excellent performance of a fledgling fund. Newer funds may start out with high performance, but that performance can fizzle out over time as the fund grows and diversifies.
6. Look at Costs and Fees
You'll also find details on a mutual fund's costs in the prospectus. Understanding how a mutual fund's fees work is an important step in choosing a fund.
One key figure to note is the fund's expense ratio, which is the fee you'll pay each year for your investment. It's expressed as a percentage of the fund's average net assets.
For context, in 2022, the average expense ratio for equity mutual funds was 0.44% and the average expense ratio for bond funds was 0.37%, according to the Investment Company Institute. One way to determine if a mutual fund is costly or not is to compare its expense ratio to this benchmark.
The Financial Industry Regulatory Authority offers a fund analyzer tool that lets you calculate how a fund's fees would eat into your returns. This can give you a sense of whether investing in a given fund is a good deal, or compare one fund to another.
Aim for Diversification
Creating a diverse portfolio—one that exposes you to many different asset classes—is a tried-and-true approach to building long-term wealth. Mutual funds can help you put together a balanced portfolio that exposes you to a measured amount of risk while opening you up to potential growth. That makes them a robust way to build a portfolio. And, you can fit them into a tax-advantaged investing plan if you invest in them within your 401(k) or IRA.
If you need individualized advice on picking mutual funds, consider working with a financial advisor. They can help you create a portfolio that helps you reach your goals, plus understand how funds can fit into your retirement planning.