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Picking amutual fund from among the thousands offered is not easy. The followingis just a rough guide, with some common pitfalls.
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1. Check with your tax advisor prior to investing in a tax-exempt or tax-managed fund.
2.Match the term of the investment to the time you expect to keep itinvested. Money you may need right away (for example, if your carbreaks down) should be in a money market account. Money you will notneed until you retire in decades (or for a newborn’s college education)should be in longer-term investments, such as stock or bond funds.Putting money you will need soon in stocks risks having to sell themwhen the market is low and missing out on the rebound.
3.Expenses matter over the long term, and of course, cheaper is usuallybetter. You can find the expense ratio in the prospectus. Expenseratios are critical in index funds, which seek to match the market.Actively managed funds need to pay the manager, so they usually have ahigher expense ratio.
4.Sector funds often make the “best fund” lists you see every year. Theproblem is that it is usually a different sector each year (internetfunds, anyone?). Also, some sectors are vulnerable to industry-wideevents (airlines do come to mind). Avoid making these a large part ofyour portfolio.
5.Closed-end funds often sell at a discount to the value of theirholdings. You can sometimes get extra return by buying these in themarket. Hedge fund managers love this trick. This also implies thatbuying them at the original issue is usually a bad idea, since theprice will often drop immediately.
6. Mutualfunds often make taxable distributions near the end of the year. If youplan to invest money in the fund in a taxable account, check the fundcompany’s website to see when they plan to pay the dividend; you mayprefer to wait until afterwards if it is coming up soon.
7. Research. Read the prospectus (How to read prospectus? http://mutualfund.9trading.com/prospectuses.html),or as much of it as you can stand. It should tell you what thesestrangers can do with your money, among other vital topics. Check thereturn and risk of a fund against its peers with similar investmentobjectives, and against the index most closely associated with it. Besure to pay attention to performance over both the long-term and theshort-term. A fund that gained 53% over a 1-yr. period (which isimpressive), but only 11% over a 5-yr. period should raise somesuspicion, as that would imply that the returns on four out of thosefive years were actually very low (if not straight losses) as 11%compounded over 5 years is only 68%.
8.Diversification can reduce risk. Most people should own some stocks,some bonds, and some cash. Some of the stocks, at least, should beforeign. You might not get as much diversification as you think if allyour funds are with the same management company, since there is often acommon source of research and recommendations. The same is true if youhave multiple funds with the same profile or investing strategy; thesewill rise and fall together. Too many funds, on the other hand, willgive you about the same effect as an index fund, except your expenseswill be higher. Buying individual stocks exposes you tocompany-specific risks, and if you buy a large number of stocks thecommissions may cost more than a fund will.
9. The compounding effect is your best friend. A little money invested for a long time equals a lot of money later.
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