When you sign up to participate in a 401(k) plan at work, you may have the chance to choose between the different mutual funds the plan offers. Also, when you invest privately, mutual funds can be a good way of starting out as an investor or to diversify your portfolio if you already have investments. In both cases, you want to know which mutual fund is the best for you. And it may be possible that it is to your advantage to invest in more than one mutual fund.
There are many different mutual funds for many different preferences, and undoubtedly there are various that can suit you. For your 401(k) plan, you will probably be presented with a list of the mutual funds in which you can invest. And even when the list is limited, there will probably be alternatives that accommodate your objectives.
When you are thinking about investing in one or more mutual funds on your own account, you have the whole range of possibilities to choose from. By establishing some criteria and doing some research and evaluation, you can select the mutual funds that are most advantageous for you.
Your Own Investment Objectives
What you should consider first when selecting a mutual fund is your own financial situation and what you want to get out of your investment. Some factors to consider are your age, your income, your savings and other investments, your risk tolerance, your need for security in your investments, and your plans for the future.
When you depend on your 401(k) for your retirement and are nearing retirement age, it will be important that the mutual funds you select offer you the degree of security you need. In this case, mutual funds that invest in federal government bonds or high quality bonds issued by large companies, where the risk is minimal, will probably be advantageous for you.
When you are younger and the 401(k) plan constitutes your only investment, it may be preferable to have a combination of mutual funds, some that provide a greater degree of security and others that offer a greater return in exchange for a little more risk. You could also choose a mutual fund that invests in bonds, for security, and a combination of other funds that invest in stocks, in order to generate a higher return in exchange for more risk.
One strategy for investing and diversifying your mutual fund portfolio is according to life cycle. According to this strategy, the composition of mutual funds changes as you get older. A younger investor would have a large percentage of the portfolio in variable income mutual funds, maybe in growth funds, and an older investor would have a greater percentage in fixed income funds that are more secure.
Security, Risk, and Return
Each person has his or her own preferences with regard to the security of investments and the selection of mutual funds should reflect these preferences. For a conservative investor, the best option may be mutual funds that invest exclusively in money market bonds or securities. Mutual funds that invest in U.S. Treasury bonds are among the safest. For a more aggressive investor, there are growth funds and funds that invest exclusively in stocks of companies in emerging markets.
It is also possible to invest in balanced mutual funds that manage a combination of investments in different instruments, in order to offer security and at the same time generate a reasonable return. Another possibility is index funds that try to mitigate risk and generate returns by making investments based on some general index, with the idea that the return will not beat the market, nor will it be worse. You can achieve a balance between security and greater returns in exchange for greater risks by having investments in different types of mutual funds at the same time.
Diversification is an aspect closely related to security. If you have all your money in just one type of investment, you run a greater risk of loss. When you have your investments distributed among different instruments and funds, you are mitigating the risk. But in addition to protecting you against the risk of loss, diversification also serves to take advantage of good opportunities that arise in different securities, companies, market segments, and regions of the world at different times.
You can diversify your portfolio of investments among fixed income investments, such as savings accounts, and money market instruments like certificates of deposit, and mutual funds that invest in bonds; and variable income investments such as mutual funds that invest in stocks. And you can diversify your portfolio even more if you have investments in mutual funds that invest in large-cap, mid-cap, and small-cap companies; funds that invest in different sectors of the market, such as technology, finance, manufacturing, services, telecommunications, and retail; and international mutual funds that invest in a particular region of the world, or in emerging markets.
You want to invest in a successful mutual fund that generates gains and not losses. The success of a mutual fund depends on its management team and the investment decisions it makes, the performance of the companies in which the fund invests, and economic conditions in general. The yield for you as an investor will also depend on the commissions and fees the mutual fund charges you.
When you are evaluating the yield of a mutual fund, you should take into account:
The fund’s objective:
When the objective of the fund is to invest in Treasury bonds, you cannot expect a rate of return greater than the effective interest rate these instruments pay. On the other hand, for a growth fund, the expected return is greater. Likewise, when you are evaluating a mutual fund that invests exclusively abroad, the expected return may be different than the return you could expect from funds that invest in the U.S., and could be higher or lower, depending on economic and market conditions in different parts of the world.
The fund’s historical performance:
Although past performance is no guarantee of future performance, by reviewing a fund’s performance during the past few years, you can gain an idea of the fund’s success. In order to see a trend in the fund’s performance, you should look at several years and not just the last year or the best year.
The overall performance of the securities market:
When the indices of all the securities exchanges are rising, you could reasonably expect that the yield of the mutual fund you are evaluating would also rise. And on the contrary, when economic conditions in general are difficult, the expectation for a mutual fund in particular should take these conditions into account.
How the mutual fund’s performance compares with the principal indices and with other funds:
It’s important to compare similar mutual funds according to their investment objectives. For example, it’s not reasonable to compare the return of a mutual fund that invests in government bonds with a growth fund that invests in stocks. But it would be reasonable to expect a diversified mutual fund that invests in stocks in all segments of the market to yield a return equal to or better than the overall average for the corresponding index.
Mutual fund expenses:
The commissions and fees you pay could determine whether you have a net gain or loss on your investment, or could at least decrease your gain or increase your loss. For example, if the mutual fund charges you a commission of 5% when you open your account, the fund would have to generate a return of more than 5% in order for you to realize a gain on your investment.
Turnover in the mutual fund:
This is the frequency with which securities are bought and sold in the fund. A high rate of turnover could make the return more unstable, depending on movements in the market for the securities.
When you want to know more about a particular mutual fund, you can study a report called the prospectus. When you choose the funds in which you want to invest the money you have in your 401(k) plan, your employer may be able to provide you with this report. And when you are thinking about investing in a mutual fund on your own account, you can request a prospectus directly from the mutual fund itself, or through your securities broker.
The prospectus is a report that explains the technical aspects of the administration of the fund and sets out the objectives and policies of the fund, in terms of whether it is a fixed income, variable income, growth, income, or balanced mutual fund. The prospectus includes a general description of the fund and the investments the fund makes, whether in bonds, stocks, other instruments, or some combination. It may include an indication of the types of companies in which the fund invests, when the fund invests mainly in stocks, or the types of bonds the fund purchases, when it invests principally in bonds.
The prospectus contains financial information that shows the gains, in dividends, interest, and capital gains paid per share, the total income and expenses per year, and the fund’s annual yield. There will be an indication of how the fund’s administrative costs are charged, whether in the form of commissions that are charged when you buy shares in the fund, which is called a front-end load fund, or when you sell or redeem your shares, which is called a back-end load fund. Or there could be just fixed fees in the case of a mutual fund that does not charge commissions, which is a no-load fund.
There may be an explanation of the potential risks of investing in the fund, and the strategies the fund manager uses to mitigate those risks. The prospectus may also include more information regarding its management, such as a description of the management team, its experience and possibly the names of the members of the board of directors.
There should also be an explanation of the fund’s operations, such as how to open an account, whether you can perform transactions by telephone, how reinvestments and withdrawals are done, and how dividends and other distributions are paid. And the prospectus will indicate the taxes that apply on income from the mutual fund and how the income is reported for tax purposes.