Financial markets involve risks as well as rewards. One way investors can manage these risks is diversification. Another is professional management. Mutual funds offer both.
Investors should look for a fund that matches their financial objectives. Do they want maximum safety or high growth or something in between? There are conservative funds that look for safe investments and aggressive funds that go after the largest returns.Many funds buy only stocks, while others favor bonds. Some funds concentrate on specific industries.
When deciding on a mutual fund, "look at how well that particular fund has done," said A. Michael Lipper, president of Lipper Analytical Services, which tracks 2,650 mutual funds.
"Try to find a period it has done badly and ask yourself, can you tolerate that? Some funds do well in up markets and some do well in down markets, but very few do well in both."
The best mutual funds to buy are not always those at the top of the performance lists. "Investors should look at funds in the reverse order of performance - meaning the ones on the bottom should be looked at more carefully, due to the rotational nature of performance," Lipper said.
Some funds, such as those that specialize in particular industries, have their fortunes tied to factors beyond their control. For example, when gold prices were high, the gold funds prospered. Now that gold prices have plunged, the gold funds are doing poorly. A description of a fund's strategy, as well as its holdings, can be found in its prospectus.
For investors who wish to build a portfolio of mutual funds, Lipper suggested five types of funds to put in it: a money market fund to provide access to cash, a bond fund, a small-company growth fund, a fund investing in large-company stocks and a specialized fund that invests in natural resources or foreign securities.
Mutual-fund fees can be a sticking point. Some funds, called no-load funds, do not charge any sales fee. Other funds charge up-front and exit fees up to 8.5 percent of the total purchase price, meaning that less of the investor's money goes toward buying fund shares.
Some funds have charges for marketing costs, known as 12b-1 fees after a Securities and Exchange Commission ruling. They can cost as much as 1.75 percent of the total investment. Others charge separate management fees, which can run to 1.25 percent.
Then there is the expense ratio, which is a fund's annual expenses divided by average net assets. This charge can range from four-tenths of 1 percent to 2 percent.