Do This, Don’t Do That: Guide to Buying Mutual Funds

Build your nest egg by learning the basics of buying mutual funds. Getty Images

Before you buy a mutual fund, you will need to spend a little time learning the basics and studying a guide of best practices for investing in mutual funds. Success in almost anything and everything you seek to accomplish begins with knowing what to do and knowing what not to do.

Here are the Do’s of Buying Mutual Funds:

A mutual fund is an investment security type that enables investors to pool their money together into one professionally managed investment. Mutual funds can invest in stocks, bonds, cash and/or other assets. These underlying security types, called holdings combine to form one mutual fund, also called a portfolio. In simple terms, a mutual fund is like a basket that holds other investments. Therefore, when an investor buys a mutual fund, they may be buying a basket of a certain type of stocks, bonds (or both), plus cash securities.

If you are a beginner, your first mutual fund may be one of the best S&P 500 Index funds that invests in around 500 of the largest U.S. stocks or it may be a balanced fund, which will provide a balance of stocks and bonds just right for you and your investment objective. Just know that there are more fund types than just stock funds and bond funds and be sure to understand which is best for you.

Risk tolerance is an investing term relating to the amount of market risk, especially the volatility (ups and downs), an investor can tolerate. Usually gauged by a calculator or questionnaire, risk tolerance is often used to categorize investors as Aggressive, Moderate or Conservative. For example, if you don’t mind fluctuations in your account value and if you have more than 10 years until you need the money, you may be an aggressive investor and can begin building an aggressive portfolio of mutual funds. However, keep in mind that risk tolerance questionnaires can only guess at how you may react emotionally to market conditions. For example, if you have never owned stock mutual funds and held them through a 10% or 20% decline in value, you may not fully understand or realize how you will react when this occurs. Most investors consider themselves as moderate or medium-risk investors, which means that a moderate portfolio of mutual funds or moderate balanced fund would be appropriate for them.

When you begin reviewing specific mutual funds, be sure to check out the prospectus, which is similar to an owners manual for mutual funds. The prospectus will include information about the fund’s objective, strategy, risk, performance, fees and expenses. Most sites will offer links to PDF copies of their funds’ respective prospectuses. Even better, some fund companies provide links to a summary prospectus for each of their funds. These are usually around 10 pages and are much easier to read than a full prospectus, which tend to be filled with financial data that is not absolutely necessary to know (or easy for beginners to understand).

When you read the prospectus, you will want to look for the fees and expenses for the fund. An example of a fee might be $20 per year if account balance is below $10,000 or something similar. However, expenses will represent the costs of managing the fund. These costs will include research, trading, marketing and other items necessary to manage the portfolio. The average mutual fund expense ratio is roughly 1.25%. However, you should be able to find good funds with expenses below 1.00%. Some funds, such as actively-managed funds or foreign stock funds will have higher expense ratios because they require more money to manage.

No-load funds often have the lowest expense ratios because there is no sales charge (load). These charges are usually front-load (paid when buying fund shares) or back-load (paid when selling fund shares). If you are a do-it-yourselfer, there is no reason to pay a load because these charges are intended to pay commissions to compensate a broker or adviser for their services. When you do your own research and buy your own mutual funds, don’t pay more than necessary! You can verify that the fund is indeed a true no-load fund by looking at the prospectus and/or looking at the fund companies website.

In addition to reviewing the prospectus of summary prospectus, you can find all the information you need about performance history, expenses, fees, fund management, and the type of fund at a mutual fund research site, such as Morningstar. who is famous for their star rating and analyst rating. and you can also look at Lipper Leaders or the Kiplinger Mutual Fund Finder tool .

Manager Tenure refers to the amount of time, usually measured in years, a mutual fund manager or management team has been managing a particular mutual fund. Manager tenure is most important to know when investing in actively-managed mutual funds. This is because they are actively trying to beat the market or an index such as the S&P 500. However, passively-managed (index) funds are only trying to match the market or index, not beat it. Therefore manager tenure is not important because there is no research or timing involved.

Also, when looking at a mutual fund’s historic performance, be sure to confirm the manager or management team has been managing the fund for the time frame you are reviewing (or longer). For example, if you are reviewing the 5-year return of a mutual fund but the manager tenure is only one year, the 5-year return is not meaningful in making the decision to buy this fund.

You’ve already learned the basics you need to remember when buying a mutual fund but you will eventually want to learn a few relatively advanced research tips such as looking for low turnover ratio and if you are investing in a regular and taxable brokerage account (not an IRA or 401(k)), you may want to learn about how to find tax-efficient funds .