Your first task is to formulate your investment objectives and identify your time frame. Find which types of mutual funds are aligned with your investment goals, risk tolerance, and time frame. Take a closer look at the fund, particularly the fund’s prospectus for fees and expenses, and performance.
Choosing mutual fund investments from the thousands of fund offerings available can be daunting. With so many different categories of funds and fund families, it may make sense to work with your financial advisor. Here are some steps experts recommend you consider when selecting investments.
There are a vast number of mutual fund offerings available to choose from and the process can be intimidating even for a seasoned professional. With so many decisions to make along the way and so many factors to evaluate such as which categories of funds or fund families are right for you, it may be sensible to work with your financial advisor to guide you along the way. Here are some basic guidelines to adhere to when selecting investments.
Evaluate Your Investment Objectives
Before you set out to start picking funds, you first need to step back and design a clear picture of your investment objectives and identify the time frame you have to work with. For example, you may plan to start a business in two years, invest in your children’s education in 10 years, or fund your retirement in 30 years.
Generally speaking, the longer your goals are, the more time you have to save and invest your money, and the greater your tolerance for risk might be. If you have an investment time frame of 10 years or more, you may want to take on more risk so that you can position yourself to potentially earn more over time by investing more aggressively in stocks with good growth prospects.
However, if you know your investment objectives, say purchasing a house, are less than five years away and you will need funds to cover your purchase, you may want to allocate your portfolio with more conservative, income-producing securities such as dividend-paying stocks or short-term fixed income securities.
Try to match your goals with the goals of the fund you choose
After you develop and clear understanding of your investment objectives with your financial advisor, the next step is to identify which mutual fund categories and types will most closely match your investment goals, risk tolerance, and time frame.
With thousands of mutual funds currently available for investors, there are certainly plenty of options to pick from, whatever your goals are. But don’t be overwhelmed by the endless number of funds and differentiation within those funds that are available in the mutual fund industry, because essentially all the funds can be boiled down to several large groups.
So think about your investment objectives and what you need to fill the void with in order to get you there – is it income? or growth? an income-growth combination? – and then match that with the investment objectives of the fund.
For instance, stock funds’ objectives typically include “aggressive growth,” “growth,” or ” growth and income” depending on the underlying securities they hold. Furthermore, each of those funds can also be categorized by a risk level such as high risk, average risk, or low risk.
There are a number of resources available to help you boil down your search for mutual fund objectives and risk levels that are aligned with your financial objectives and risk tolerance in an organized and informed way such as Morningstar, Lipper Analytical Services, Standard & Poor’s, and Value Line, along with many other publications.
Standard & Poor’s, for example, categorizes stock funds into five major categories from which each fund is then categorized by fund investment style, risk level, performance, and an overall risk-adjusted rating in relation to other funds in the same category.
Once you have narrowed down yourself to the fund categories that seem appropriate to your investment objectives, you should start looking into the individual funds of each of your categories. Performance over time is an important metric to take a look at first, but certainly should not be the only consideration.
Other important factors may include the consistency of the fund manager, the fund’s style, and even the fund’s returns. For instance, do the returns show wild swings from year to year, or are they within a certain level over time?
In addition to third-party resources on mutual funds such as Standard & Poor’s, Lipper Analytical Services, personal finance magazines, and so on, you may also want to read the material available by the fund company. Most importantly, you will need to carefully look through the mutual fund’s prospectus, which is available free from the fund company.
A fund’s prospectus outlines the fund’s investment objectives, what type of securities it invests in, and the risks associated with the investments involved. The prospectus can be greatly helpful in helping you understand what you are exactly investing in.
For instance, a prospectus from an aggressive growth-oriented fund may tell you that it invests in small-cap stocks that can be volatile, that it uses other products as part of its investing such as derivatives to hedge against downside risk or maximize investment returns, and that the fund involves taking a higher than average risk.
Fund prospectuses also let investors know the fund’s performance, fees and expenses, and other information that should be carefully scrutinized when choosing mutual funds for your portfolio. Given your unique time frame and appropriate risk level, performance over the specific time period you need along with the appropriate fund risk level is a good measure of how well the stock fund will fit into your portfolio as part of your overall investment strategy.
So when you are doing your due diligence, don’t get caught up in the fund’s latest performance figures solely, but look at the fund’s performance figures over time.
A common misconception and often mistake is that of buying the latest “hot” mutual fund. In fact, buying into a fund solely based on its last performance figures can be very risky, because only 39% of domestic equity fund managers beat their benchmark during the recent five-year period. So it is not easy to consistently outperform the benchmarks especially when a fund is on a hot streak already.
Instead, look at funds that consistently provide above-average investment returns in their category over the past three years, five years, and 10 years periods. Volatilities can give investors a good understanding of how the fund performs in bull markets as well as bear markets. Lower volatility can signal that the fund may do well during good markets but also potentially not do less than the averages in down markets
Additionally, compare the annual percentage returns of the fund with its major benchmark index. For example, compare a diversified large-cap stock fund with the S & P 500 stock index. Mutual fund performance benchmarks are listed each quarter in major financial publications through their websites.
Fees and expenses are also important elements to look at when looking at the mutual fund you’re interested in and those charges vary widely from fund to fund. Some funds impose a sales charge when you buy shares (these are considered front-loaded funds);
others may have an exit charge if you sell shares before a time frame set by the fund’s prospectus, and others can have no loads for getting into the fund and selling out of the fund.
In many cases, you are better off working with your financial advisor to decide if it makes sense to pay a load or not. For a truly superior fund, it may be worthwhile to pay a load, especially if you are looking to invest in the fund and stay there for a long period of time.
In addition to sales charges, consider the various management fees the fund charges. Everything being equal, lower total fees and expenses result in higher returns.
ABOUT THE AUTHOR: Yulian Isakov