Success in mutual fund investment will depend on first identifying your investment goals and tolerance for risk. Conventional wisdom holds that younger investors can afford to take bigger risks, since they can ride out market fluctuations over the long term, whereas investors closer to retirement age should choose less volatile funds. However, there are numerous other factors to consider.
The first question to ask yourself is: why mutual funds? Generally, people are drawn to mutual fund investment as a way of diversifying their investment capital. Instead of attempting to pick individual stocks and bonds, and incurring the fees associated with those buys, investors can buy into a fund that will do that work for them. Most mutual funds are overseen by a manager who makes decisions on how to invest the fund’s capital.
The vast majority of mutual funds are equity funds, which invest primarily in the stock market. There are countless equity funds to choose from, but they can be broken down into two major categories, based on their underlying philosophies. These two main types are: growth funds and value funds.
Growth funds are the riskier of the two types of equity funds. Growth funds seek out the fastest-growing stocks in the market and attempt to ride their growth to higher share value. This can reap big rewards, but can also lead to big losses if an expensive stock buy goes south. Growth fund managers tend to do a lot of buying and selling in their attempts to ride market waves, which can drive up the investor's costs through higher fees and tax liabilities.
Value funds, on the other hand, generally seek out companies believed to be undervalued in the market relative to their earnings potential. The upside to this strategy is that many of the stock buys are inexpensive, so there’s less money to be lost if a given buy doesn’t pan out. Value fund managers also tend to hang onto stocks for a longer period of time, leading to fewer expenses and tax liabilities. On the other hand, undervalued companies may continue to be undervalued, or may rise in value only in slow increments.
For any mutual fund investment, it’s crucial to thoroughly review a fund’s prospectus. The prospectus will tell you about a fund’s short- and long-term objectives, and provide figures on past performance. Don’t fall into the trap, however, of judging a fund solely on past results, since market conditions fluctuate. A fund investing primarily in one sector of the U.S. economy, for instance, could flourish one year and falter the next.
One of the most important things to consider before purchasing mutual fund shares is what costs you’ll incur beyond the share price. Fees come in two varieties: loads and expense ratios. The load is a percentage-based fee taken out of your initial investment. Expense ratios, on the other hand, are assessed either quarterly or annually, to cover a fund's management and administrative costs. These fees, though they may appear small, can have a large impact on your investment capital over the long haul, particularly since expense ratio fees are assessed regardless of whether the fund makes or loses money.
The other number to look for in a prospectus is turnover, which tells you how often the fund is swapping out one stock for another. Higher turnover usually means higher fees, and also higher tax liability, since each stock sale can result in taxable capital gains.
If you want to minimize costs, a popular strategy is to invest in index funds. These mutual funds do not employ a manager. Instead, they invest in the stocks of a given index, such as the S&P 500 or the Nasdaq 100. These funds, then, will mirror either the stock market as a whole, or a particular segment of the market, and often come with no load and minimal expense ratios.
If you're investing for retirement, you should check to see if your employer sponsors a 401(k) plan. The advantage of a 401(k) is that your investment will come from your paycheck pre-tax. Some employers even match a percentage of your 401(k) contributions. Of course, it's wise to look into the specifics of a 401(k) plan to make sure it matches your investment goals. Many 401(k) plans invest in index funds, but others may be less diversified and carry more investment risk. Investing in an individual retirement account (IRA) also carries tax benefits while often giving you more choice about the kind of mutual fund you want to invest in. Either type of fund will penalize you for withdrawing money before you've reached retirement age.
If you’re looking for a shorter-term mutual fund investment, money market funds offer a relatively safe bet. These funds, by investing in low-risk debt-based securities, seek to maintain a stable share price of $1 US Dollar (USD) while providing regular income. Money market funds rarely lose value, but you can expect only modest returns, somewhere in the neighborhood of 4% to 6%. Over time, these returns may actually fail to keep up with inflation, which is why money market funds are not ideal for long-term investment growth. Money market accounts are completely liquid, meaning you can access your investment capital at any time, and can often even write checks from the account. However, it's important to remember that while they usually provide higher returns than a bank savings account, money market funds are not insured by the federal government, and thus do carry a modicum of risk.