Choosing a Mutual Fund

Sorting through the mutual fund universe is a daunting task - here are some tips to help you find the best mutual funds to reach your financial goals.

Mutual funds are an excellent investment option to diversify your money and grow it for the future.  The challenge is that there are thousands of them out there - how do you decide which are best for you?  We will discuss the major factors to take into consideration when narrowing down your list of mutual fund investments.

When choosing a mutual fund, you first need to identify the reasons you are investing. Do you want to finance your child's college education? Are you saving money for your heirs? Perhaps you're dreaming of a comfortable retirement or even an early retirement. Your goals may be just around the corner or a long way off. This timeframe is known as your investment time horizon. Your time horizon will play a large part in determining how to best achieve your goals.

For example, if your investment time horizon is less than five years, you probably should choose more conservative investments, like money market funds or dividend-producing bond funds, to help you achieve your goal. If, on the other hand, your time horizon is greater than 10 years, you may want to choose more aggressive investments that carry more risks, but with potentially higher returns, like stock funds.

Now it's time to measure your risk and determine the most suitable investments for your risk level.  Risk comes in many forms, but the main risk you face when investing in mutual funds is that your investment will lose money. Once you have an investment time horizon in mind, you will be in a better position to assess your risk tolerance level. In general, the longer you have to invest for your goals, the more risk you'll probably be able to bear. Conversely, if your time horizon is short, you'll most likely want to invest conservatively.

Time horizon is not the only factor in figuring out your risk tolerance level. You should also consider your age, income, expenses, tax situation, liquidity needs, and your investing personality. Financial markets can make some investors queasy, while others don't get the least bit flustered! Determining your risk tolerance is a very personal process. Your investment professional can help you work through this process.

Which investment type is best to match your goal and risk tolerance?  The two most general investment types are equity and income. Mutual funds and other securities are classified using these terms because they basically identify the investment goal.

Equity, in a broad financial sense, means owning interest in a corporation through its common and/or preferred stocks. (By owning stocks, investors help companies raise capital.) By investing in common and/or preferred stocks, equity mutual funds often seek to produce capital appreciation. Often referred to as growth or aggressive growth funds, equity funds tend to carry a higher level of risk and potential returns than more conservative investments. However, there are degrees of risk within various equity sub-categories (e.g., small-cap stocks are riskier and more volatile than large-cap stocks).

In most cases, the primary objective of income mutual funds is to produce current income using bonds, including government, mortgage-backed, municipal, and international bonds. Income mutual funds are often qualified with a secondary objective of either income with safety of principal (less risk), or income with the opportunity for growth (more risk). Income funds generally carry a lower degree of risk than equity funds.

Some investors prefer a combination of equity and income as an investment objective. Equity and income funds invest primarily in common stocks of companies with a history of capital gains, while maintaining consistent dividend payments. Investors with this objective should consider the total return on their investment, which includes both income and capital appreciation, instead of separating equity and income objectives.

For many investors, performance is the end-all in choosing a mutual fund. Though it is an important consideration, it's critical that you keep performance in perspective. A fund's successful record of growth is a positive indicator, but it is not a guarantee that growth will continue in the future. As you review a fund's performance, look for consistent above-average returns for the past three, five, and 10 years. If your time horizon is long, look at performance records for a similar length of time.

Additionally, a fund's fees and expenses will play a role in choosing a mutual fund. Some funds have a front-end load, which is assessed when you buy shares, and others impose a contingent deferred sales charge, a back-end load assessed when you sell shares before a certain period of time. In general, the lower the expenses, the greater the return to the investor versus a similar investment with higher expenses. However, if you've found a fund that has consistently strong performance, matches your objective and risk tolerance, but has a front-end load, you may still want to consider investing in that fund over the long term. Sales charges can be complex, especially if you're considering multiple funds, and it makes sense to consult your investment professional for assistance.

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