Investing in Mutual Funds: The Time-Tested Guidelines

Why mutual funds work for most investors

A mutual fund pools your money with other investors' and hands it to a professional manager who buys and sells securities on the group's behalf. That structure solves three problems most individual investors face on their own: research, diversification, and cost.

• You get professional management. Most people don't have the time, data, or training to properly research individual stocks and bonds, so a fund manager does that work for you.
• You get instant diversification. Owning shares in a fund spreads your risk across dozens or hundreds of underlying securities instead of concentrating it in a handful of individual picks.
• You get lower transaction costs. Because a fund buys and sells in bulk, the per-share cost of trading is typically lower than what you'd pay executing the same trades yourself.

Three things are worth keeping in mind before you buy your first fund. First, past performance doesn't predict future performance; a fund's five-star rating last year tells you almost nothing about how it will do next year. Second, mutual funds are not guaranteed or insured by any bank or government agency, even if you buy one through a bank and it carries the bank's name. You can lose money. Third, every mutual fund has costs that reduce your return, which means even a fund built to track a market index can't quite match that index's actual performance, because the index itself doesn't pay operating expenses and the fund does.

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How to choose a fund

Once you've settled on an asset allocation, mutual funds are the easiest way to implement it. You typically only need six to ten funds to achieve real diversification across your target asset classes, far fewer than the number of individual securities it would take to build the same exposure yourself.

Every fund carries investment risk, and some carry considerably more than others; a higher potential return almost always comes paired with higher risk. Don't buy into a fund without understanding, and being genuinely willing to accept, what kind of risk it carries. To choose well, look at four things for each fund you're considering:

• Its risk and reward history, and whether that profile matches your own financial situation.
• Its investment philosophy and style, and whether that matches your actual goals.
• Its costs, including any sales loads and ongoing expenses.
• The quality of customer service it offers.

It's also worth checking whether a fund closes to new investors once it reaches a certain asset size, which is common with small-cap funds. Be skeptical of recommendations that lean entirely on last year's returns; a magazine or newsletter touting last year's hottest fund is describing the past, not necessarily your future.

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Comparing performance the right way

A fund's past performance matters less than most investors assume. Rankings and advertised returns describe what already happened, and studies consistently show that this year's top-ranked fund is often next year's mediocre one. Past volatility, on the other hand, tends to be a much more reliable indicator of future volatility than past returns are of future returns.

A few practical ways to compare funds on performance:

• Check total return in the Financial Highlights section near the front of the prospectus. Total return captures the change in an investment's value over time, net of costs, though it's only one of several return measures worth looking at.
• See how the fund ranks against others in its category, using one of the available rating systems.
• Look at year-to-year total return over the full ten-year history shown in the prospectus. An impressive ten-year average can hide the fact that one spectacular year is carrying nine average ones; year-to-year variation tells you how stable the fund's returns actually are.
• Check the fund's Sharpe ratio, which measures return relative to risk. It's calculated by subtracting the average monthly return on 90-day Treasury bills, a proxy for a risk-free return, from the fund's average monthly return, then annualizing that difference and dividing it by the fund's standard deviation. The mechanics aside, the practical takeaway is simple: a higher Sharpe ratio means better performance for the amount of risk taken on.

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Comparing costs

Costs matter because they come directly out of your return. A fund charging a sales load and high ongoing expenses has to outperform a low-cost fund just to break even with it. The fee table near the front of every prospectus breaks costs into two categories: sales loads and transaction fees paid when you buy, sell, or exchange shares, and ongoing expenses paid every year you remain invested.

Sales loads. Not every fund charges one; no-load funds exist in every major category and skip this cost entirely, though they still carry ongoing expenses like management fees. A front-end load is charged when you buy shares and, by law, can't exceed 8.5% of your investment, though in practice most are lower. A back-end load, also called a deferred load, is charged when you sell, typically starting around 5% to 6% in the first year and stepping down to zero by year six or seven.

Consider a $1,000 investment in a fund with a 6% back-end load that phases out over seven years. If the investment's value stays flat at $1,000 and you sell in year one, you'd get back $940, since $60 goes to the sales charge. Sell in year seven instead, after the load has fully phased out, and you'd get back the full $1,000.

Ongoing expenses. These are shown as a percentage of fund assets and include the management fee along with any other recurring costs. Higher expenses don't buy you better performance on average, though there are legitimate reasons a fund might cost more, such as the extra research required for international stock funds, or the cost of offering services like check-writing and toll-free support lines.

Small differences in expense ratios compound into large differences over time. Invest $1,000 in a fund earning 5% annually before expenses: at 1.5% in expenses, you'd have roughly $2,012 after 20 years; at 0.5% in expenses, you'd have more than $2,455, a 22% difference. Scale that to a $100,000 investment and the gap grows to more than $44,000.

One specific ongoing cost worth knowing by name is the Rule 12b-1 fee, typically 0.25% to 1.00% of assets annually, most often used to pay broker commissions and, occasionally, advertising costs. Funds with back-end loads tend to carry higher 12b-1 fees. If you're deciding between a front-end and back-end load, your intended holding period matters: staying in a fund six years or longer usually makes a back-end load cheaper overall, though a back-end load that's fully phased out to zero can still end up costing more over time through accumulated 12b-1 fees than a front-end load would have.

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Comparing investment philosophy

Beyond costs and performance, it's worth understanding how a fund actually invests, not just what it says it does.

• Start with the fund's stated investment objective, and confirm that its actual portfolio matches that stated objective. A fund should fully disclose how it invests, and style-box tools available through services like Morningstar can help you see at a glance whether a fund's approach carries a low, moderate, or high risk and return profile, and what kinds of securities it actually holds.
• Check whether the fund invests overseas. International equities are generally a longer-term, higher-risk holding than domestic ones.
• For a stock fund, look at which industry sectors it's concentrated in. For a bond fund, look at the maturities of its holdings and whether any of its bonds are tax-exempt.
• Find out how long current management has been in place, and whether the fund's track record is really attributable to one manager. A recent management change adds a layer of uncertainty, unless the new manager brings a strong track record from elsewhere.

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Comparing customer service

Service quality is easy to overlook until you need it. Before committing, it's worth finding out how long it typically takes to reach a live representative, what account options and features the fund offers, and how quickly the fund company answers questions about your returns or holdings.

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Risk factors by fund type

Every mutual fund carries risk. You can lose some or all of your principal because the securities a fund holds rise and fall in value, and the income a fund produces, dividends and interest, can rise or fall too. The main categories of risk are volatility (unpredictable swings in stock prices), interest-rate risk (bond prices moving as rates change), credit risk (the chance that a bond issuer fails to pay as promised), and inflation risk (the chance that a shrinking dollar erodes your real return over time).

Money market funds. These are among the lowest-risk mutual funds, limited by law to high-quality, short-term investments, and they aim to hold a stable net asset value of $1.00 per share. That value can still drop below $1.00 if the fund's underlying investments perform poorly, though it's rare. It's also worth knowing that a money market fund is not the same thing as a money market deposit account at a bank, even though the names sound alike. The fund is an investment, uninsured, sold with a prospectus. The deposit account is a bank product, insured, governed by a Truth in Savings disclosure. Some bank-branded money market funds are simply run by an outside fund family on the bank's behalf, adding an extra layer of cost you might not expect.

Bond funds. Also called fixed-income funds, these carry more risk than money market funds but typically pay higher yields. Because bonds vary enormously in quality and maturity, bond funds vary just as much in their risk and reward profile. Most carry credit risk, the chance that a bond issuer fails to pay, though funds concentrated in insured bonds or U.S. Treasuries carry very little. Nearly all bond funds carry interest-rate risk: when rates rise, the market value of existing bonds falls, which is why you can lose money even in a fund holding only Treasury bonds. Longer-maturity bond funds see their value move more sharply, in both directions, than shorter-maturity funds.

Stock funds. Also called equity funds, these generally carry more volatility than money market or bond funds, but have historically delivered the strongest long-term returns. A common way to measure a stock fund's sensitivity to overall market swings is "beta." Not all stock funds behave the same way: growth funds chase capital appreciation over dividend income, sector funds concentrate in a single industry, and small-cap or international holdings tend to swing more sharply than large-cap domestic ones. Funds that use derivatives carry an additional layer of risk worth understanding before you invest; derivatives can amplify small market movements in unpredictable ways, though they don't automatically increase a fund's overall risk and are sometimes used to reduce it. A fund's prospectus will describe how, if at all, it uses them.

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Where to find the real information

The single most useful document is the prospectus, the fund's official selling document, which lays out costs, risks, past performance, and investment objectives. Request it directly from the fund or through whoever is advising you, and actually read the sections on risk and investment policy before committing money; funds that sound similar on the surface can have meaningfully different risk profiles underneath.

Every fund is also required to prepare a Statement of Additional Information, sometimes called Part B of the prospectus, which goes into more operational detail than the prospectus itself. You can request it directly from the fund. Annual and semi-annual shareholder reports are another good source for understanding a fund's actual goals and policies in practice, and funds will send these on request as well.

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