How to Pick a Mutual Fund

By Kent Ninomiya

Overview

If you pick the right mutual fund, you can make a lot of money. However, you must understand the risks involved with each mutual fund and which one is appropriate for the length of time you plan to own shares. If you pick the wrong mutual fund, you could end up losing a lot of money by cashing out when you need the funds. When picking a mutual fund, an investor must consider the level of risk he is willing to tolerate and the time horizon for his investment.

Step 1

Decide how much money you want to invest in a mutual fund. Most have minimum investment requirements. This is usually $1,000 to $3,000. Be sure that you are not investing money that you will need to pay your bills. Mutual funds are not checking accounts. They are for longer-term investments.
Step 2

Determine how long you will be investing in the mutual fund. The longer it will be before you need the money, the more risk you can take. Aggressive mutual funds tend to have share prices that fluctuate dramatically. However, over the long-term, they tend to grow more than conservative investments. Anything less than 3 years is considered short-term. 3 to 10 years is medium term. More than 10 years is long-term.

Step 3

Consider your risk tolerance for the mutual fund. A well diversified portfolio contains a variety of aggressive, mixed and conservative mutual funds. Determine which category the mutual fund falls into. Aggressive mutual funds contain mostly growth stocks. Conservative mutual funds contain large percentages of dividend-paying conservative stocks and bonds. Mixed mutual funds contain varying amounts of each. Find one that suits your risk tolerance.
Step 4

Pick between actively and passively managed mutual funds. Actively managed mutual funds have fund managers who select the investments. They charge higher fees for this service. Index funds are passively managed. They contain a variety of financial securities that mimic a particular financial index. Fees for index funds are lower. Actively managed mutual funds do not necessarily perform better than passively managed ones. In fact, the average index fund performs better than the average actively managed mutual fund.
Step 5

Read the prospectus before purchasing a mutual fund. It is a pamphlet provided by the mutual fund company that details the investment philosophy, holdings and fee structure. Mutual funds with a "load" charge a fee to buy and sell shares. "No load" mutual funds do not charge a fee to buy or sell shares, but do have maintenance fees and 12b-1 fees. These can be significant and vary between mutual funds. It's important to read the prospectus.

Skill: Moderate
Tip: Take a look at the past performance of a mutual fund. This information is located in the prospectus. Mutual fund companies are very careful to warn you that past performance is not a guarantee of future returns. While this is true, it can give you an idea how well the mutual fund is managed and how well it performed historically.
Warning:
Mutual fund investments are not the same as bank investments. They are not FDIC insured. If the mutual fund company goes out of business, you could lose all your money. Only deal with reputable mutual fund companies that have been in business for a long time.

More Essortment Articles