The 3-Step Plan to Choosing Your First (or Next) Mutual Fund

By Julie Rains on 2 July 2013 (Updated 8 July 2014) 0 comments

I still remember buying my first mutual fund when fund families sold their offerings by telephone and mail.

Research typically involved poring over the pages of reference books in the public library. So, rather than spend my time in this laborious effort, I called a fund company and started talking to one of its investment advisors. He couldn't give specific advice but helped me make a choice among his company's offerings based on my goals, risk tolerance, and preferences.

Today, you can still ask for such advice in choosing a mutual fund, either by talking to a real person or perusing pre-selected recommendations available through online brokerage firms.

However, a better process is to identify mutual funds that satisfy your criteria, make comparisons among matches, and choose one that best fits your goals and preferences. (See also: Mutual Funds for Wise Bloggers)

Even though this second approach consumes more time and you may end up selecting a fund already on your broker's list, you'll have a better idea of why the fund is right for you. This knowledge can help guide future decisions about adding shares to your portfolio, selling shares when the fund no longer meets your needs, or buying complementary funds to create a balanced portfolio.

Step 1: Think About Your Investment Goals

Start by considering your financial goals and time horizons. Generally, you'll want to save for retirement, which is likely to be 30 years or more from now. You might also decide to build wealth to start a business, buy an RV to travel the country, or earn a graduate degree in mid-life, which may be 15 or 20 years away.

To reach these goals, figure out how much you need to set aside monthly or annually. Use a personal finance calculator on setting goals (try these from Charles Schwab or Janus) or create a spreadsheet formula using financial functions such as future value.

Next, determine the asset allocation or investment mix recommended to reach your goals. You may also need to consider your risk tolerance, whether conservative, moderate, or aggressive. Again, using investing resources (such as planning your mix from Charles Schwab or Asset Allocator from Janus), you can determine the category of assets in which to invest.

Step 2: Use Screening Tools to Identify Matching Funds

There are a variety of screening tools offered by personal finance sites and online brokerage firms, such as these:

All are designed differently, giving you the opportunity to screen based on various criteria. Some give results from a prescreened list (those available from the firm's own family of funds, for example), whereas others help you find offerings from among the universe of mutual funds.

There are several criteria to consider in selecting your fund, including category, fees, past performance, turnover, and others.

Category

Choose among Large-Cap Growth, Large-Cap Value, or Large-Cap Blend, Target Date, or Market Allocation funds.

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Typically, large-cap equity dominates most asset allocations as these represent the largest, most established, and often most consistent companies in the U.S. or global economy. So, you might choose a large-cap offering as your first mutual fund. Alternatively, you could buy a fund that offers a balanced portfolio suitable for your timeframe; these may be called lifecycle, target date, or allocation mutual funds.

Fees

Select no-load funds with no transaction fees and annual operating expense ratios that are at least below the category average or ideally less than 0.5% or 1.0%.

By selecting mutual funds with low costs, you can protect your investment returns from being eroded by fees. Theoretically, funds with substantially higher market returns could easily cover costs of 1-2% or more. In practice, however, higher management costs do not consistently yield better returns. In the future, you may want to purchase potentially high-return funds despite higher-than-average costs, but for your first mutual fund, stick with lower-cost options.

Past Performance

Find funds with 5-year returns, 10-year returns, or returns since inception that meet or exceed the S&P 500 or category average.

Looking at past performance is a double-edged sword. You don't want to select a fund that has consistently been a poor performer over the long term. However, funds with more recent strong performance may be more apt to lose value in the short term. For example, in the late 1990s, mutual funds with heavy concentrations in the technology sector experienced strong gains followed by significant losses. In short, don't "chase performance" or buy high-priced funds at their peak, but don't buy consistently low-performing funds either.

Turnover

Choose the category average or a lower percentage (50-75% or less) if you are looking for a more stable fund.

Turnover represents the frequency in changes of the mutual fund's holdings. Fund managers will buy and sell stock based on investment strategies. But this turnover in underlying stock can trigger capital gains, fund distributions, and tax liabilities that erode returns if you are holding the fund in a taxable account. Note that funds with turnover of 25% or less tend to be index, allocation, or target date funds with little activity.

Other Factors

You can apply many more screens relating to factors such as risk, fund manager tenure, and minimum investment. Some screens have overlapping purposes; for example, you could look at the tax efficiency of a mutual fund rather than its turnover to gauge the impact of the investment strategy on taxes.

Step 3: Choose a Mutual Fund From Your Filtered Matches

After you've narrowed your selections to a manageable assortment, choose a few to compare. Determine which funds excel in certain areas; for example, both may have expense ratios that are less than 1%, but one may have dramatically lower expenses in comparison to the other.

Record the names and/or tickers of the mutual funds you want to investigate. Research your selections by reviewing the prospectus, checking out its major holdings, and reading analyst reports. When you are ready, buy shares in the fund that best fits your needs and wants.

Are you ready to invest in mutual funds? How will you choose the best one for you?

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