How to Choose Mutual Funds in 4 Steps

So you’ve decided to invest in mutual funds. Now comes the hard part — which ones?

There are more than 7,000 mutual funds in the United States^[0]

How to choose mutual funds

1. Decide whether to go active or passive

Do you want to beat the market or try to mimic it? It's a fairly easy choice: One approach costs more than the other, often without delivering better results.

Actively managed funds are managed by professionals who buy and sell investments for the fund. It has proved very difficult to outperform the market over the long term and on a regular basis. Professionals rarely achieve it, so why pay more for your fund to underperform?

Passive investing is a more hands-off approach. Index funds track an existing market index. Since these passive funds don't employ a fund manager they're often cheaper, and they tend to perform better than actively managed funds.

» Check out the best index funds

2. Calculate your budget

Once you meet a mutual fund's minimum investment amount you can often choose how much money you’d like to invest. Many mutual fund minimums range from $500 to $3,000, though some are in the $100 range. Some even have a $0 minimum.

Figure out how much money you have to comfortably invest and then choose an amount.

3. Figure out your risk tolerance

Generally speaking, the closer you are to retirement age, the more holdings in conservative investments you may want to have. Younger investors typically have more time to ride out the highs and the lows of the stock market. Over time, those peaks and valleys tend to look like a gentle upward slope.

4. Think about your asset allocation

Your asset allocation is the composition of your portfolio. If you're just starting out it may be a good idea to look into broad mutual funds that invest in different arenas of the stock market. One way to do this is by looking at a market index. The S&P 500, for instance, covers around 500 of the largest companies in the U.S. If you invest in a mutual fund (likely an index fund) that tracks the S&P 500, your investment performance should mirror that of the index.

But you don't have to just invest in funds that track the market. If you are already invested in some broad market index funds you can explore mutual funds that focus on geography (think stock markets in Europe or Asia), different company sizes (small cap versus large cap) or specific sectors (funds that focus on oil, clean energy or technology stocks).

» What’s the right number of funds? Here’s our guide on how many funds to buy

How not to buy mutual funds

Now that you know what to look for, here are some common mistakes people make when choosing mutual funds.

Chasing hot-performing funds

Chasing performance often results in the opposite effect: buying a fund when returns are high and selling when returns sag. The chase can be a costly game of whack-a-mole, striking just as hot performance cools.

Study after study shows that a fund’s recent track record is a poor way to gauge future returns. Investors should consider other factors too, such as its assets under management, fees and holdings.

» Get started: Learn how to invest in mutual funds

Following a suggestion from family or friends

So if you can’t can’t rely on a fund's performance to make your choice, whom can you trust? Many new investors lean on those closest to them.

Even in the digital age, word of mouth carries a lot of weight, especially when it comes to facing big financial questions. But unless your friend, colleague or family member is on the same financial footing as you, there’s a high risk that the fund you chose on hearsay is a bad match, experts warn.

Pick the funds with the highest star ratings

Morningstar, an investment research firm, publishes an influential list of mutual funds ranked from one to five stars. So, just pick the fund whose star rating is the highest, right?

Well, Morningstar itself notes that its star system “is intended for use as the first step in the fund evaluation process. A high rating alone is not a sufficient basis for investment decisions.” Start your research there, sure, but do additional due diligence as well.

Thinking bonds are too boring

New investors get into mutual funds for long-term growth, which is why equity mutual funds are one of the most popular kinds of mutual funds. Equity funds track the stock growth of a large swath of companies by index, industry or country.

Bond funds are less risky and their underlying asset is government or company debt. The investor lends money for a set period of time, with the promise of repayment of the original investment plus interest. While stocks offer greater potential for long-term growth, bonds can balance out the risk in your portfolio by offering a steady stream of income.

Ignoring the fees

Another common misstep is choosing a mutual fund without understanding the long-term impact of fees — also known as the expense ratio — on total returns. Fees vary depending on whether you choose a passive fund — one that tries to mirror the growth of an index like the S&P 500 index of large companies, for example — or an actively managed fund, which aims for market-beating performance and is costlier.

The fees as a percentage of total investments may seem low compared to the double-digit interest rates you see on a credit card statement, but they can quickly eat into your returns.

» What's the cost? Mutual fund fees investors need to know

Say you had $100,000 in a fund, and that fund delivered 7% returns annually. After 30 years, you'd be very happy. But the fund's expense ratio would affect just how happy you'd be.

Passive funds charge lower fees and tend to have better returns, making them the best choice for many investors. If you're interested in an actively managed fund, Kinney recommends looking for funds that have the lowest fees and the highest buy-in from the fund manager. “It’s important that they have skin in the game,” he says.

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