Choosing the correct mutual fund is a bit like choosing the right kind of stocks to buy. One rule of thumb is watching the fees. But you also should keep in mind the matter of diversifying your holdings to lessen risks and not chasing performance but instead thinking long-term.
Fund diversification
Let’s begin by looking at diversification. If your company offers a 401(k) plan, then you likely have numerous funds that you can choose from. You never want to put all of your investments into one fund. It is risky, and that’s why you need to hold a diversified portfolio. A smart fund strategy will merge bond and stocks funds, along with those funds investing in domestic and/or overseas markets.
A solid strategy will also incorporate “rebalancing.” Each year, examine the mix of funds you hold to make sure they still come together with your diversification strategy. If one of your strategies has done really well, it should be a huge part of your fund portfolio. Every year, when you rebalance your funds, it will let you avoid overexposure to any one portion of the market.
Mutual funds types
There are thousands of funds available along with dozens of strategies to implement. Here are a few:
Balanced funds
These invest in a blend of bonds and stocks. Typically, balanced funds have a rather conventional mix of about 40% in bonds and 60% in stocks.
Actively-managed funds
Here, the portfolio managers spend a great deal of time researching the enormous investment universe and then picking and purchasing things that match their investment strategies. Typically, they are attempting to outperform specific indexes. For example, rather than trying to track the S&P 500 index, an active US stock fund manager will attempt to beat it.
Index funds
Index funds invest in a portfolio of securities representing the whole stock market or a specific piece of a market, such as small companies or international stocks. These funds are built to duplicate the relevant market’s performance – they should track that market’s indexes. For example, an S&P 500 index fund aspires to provide the exact same return as the S&P 500 index. These are low-cost and low-maintenance funds.
Lifecycle funds or target date funds
These invest in a mixture of stock and bond funds. Basically, lifecycle funds are a combination of other mutual funds. As the investor gets older, the ratio of money allocated to stocks compared to bonds becomes more conservative. For example, a 2040 retirement fund could be 85% stocks and 15% bonds now, but in 2040, it could be 50% bonds/cash and 50% stocks.
These work well when you would prefer not to pick and choose what to buy on your own, but rather have somebody else manage it for you. You just need to determine which year you plan to retire and then choose the fund that most closely matches that date.
Lifestyle funds
Lifestyle funds invest in a mix of stock funds and bonds funds that doesn’t change over time. Some lifestyle funds add an additional fee in addition to the expenses of the underlying funds. This type of fund is usually best avoided.
Tax-managed funds
These funds try to minimize taxable capital gains and other distributions to fund holders, which is why they tend to be recommended to investors buying them via normal, taxable brokerage accounts, rather than through IRA’s or 401ks.
For 401(k) investors
If you are a 401(k) investor, you have access to a number of funds your employer has chosen. If you want to invest outside of your employer-sponsored plan, there are a number of options for you:
- You can buy mutual funds directly through the fund companies.
- You can purchase funds using the “supermarket” which offers funds from various providers. Pay close attention to fees.
- You can purchase funds through a broker or specific financial planner. This route generally will be less cost-effective than others, because brokers tack on additional fees.
After you settle on a strategy for your expected needs, it can be confusing to pick from the world of funds. After all, there are thousands of funds that compete for your attention. When you consider a fund, a good starting step is to look at the prospectus. It contains information about risk posture, investment goals, fee information, amount of assets held, and past performance data.
Did you find our advice useful? Express your opinion in the comments below and see our beginner’s guide to mutual funds and find out how to choose the best mutual fund for you.
Need more advice? Don’t hesitate to check out our complete guide to investing into stocks and bonds and learn how to anticipate market movements and navigate the trading field.