How to Choose a Mutual Fund

The new year is coming, and with it undoubtedly many financial resolutions. If you're ready to take the important leap into investing, you might have heard that mutual funds are the way to go, but with so many choices, how do you know which ones to pick?

Stick with index funds. First, narrow down the field by resolving to buy an index fund--and not just any old index fund, but an index fund that tracks one of the major U.S. stock market indices, like the S&P 500 or the Russell 2000. Index funds are considered a good bet because they try to track the market rather than trying to outperform the market. Trying to outperform the market is a bad idea because this strategy usually fails. Thus, the best way to get the highest returns is to settle for the market average, which is historically about 9-10% per year for the S&P 500. Keep in mind that you won't be earning ten percent every year; rather, some years you may lose fifteen percent, some years you may gain thirty percent, and other years you may just gain two percent. It's the average that counts, so you'll want to keep your money in the same index fund for a long time.

Low expenses are key. That brings me to my second point. Since you're going to keep your money in the same fund for a long time, you'll want to pick a fund with low expenses. Over time, funds with low expenses tend to outperform funds with high expenses because high expenses drag down your returns. Also, funds with higher expenses tend to be actively manged funds, and actively managed funds tend to try to beat the market, and if you were paying attention to the first tip, you already know what happens when you try to beat the market. Most basic investment advice says to stick to funds with an expense ration of 1.0% or less; I like to stay significantly under that because it's easy to do so, especially if you choose Vanguard funds, many of which have particularly low expense ratios of around .2%. The Fidelity 500 Spartan fund only charges only .1%, which is phenomenal. You will never actually see this expense deducted from your account, but it's money that you will never receive as a return on your investment.(Some investors might argue that it doesn't matter what a fund's expense ratio is as long as your total returns are high, but I think that theory is highly debatable due to the other tendencies of funds with high costs.) You should also avoid funds with 12b-1 fees. 12b-1 fees are used for advertising. Investors shouldn't have to shoulder that expense--the investment companies should.

You'll also want to make sure that you choose a no-load fund. A load is a fee that you pay when you put money into or take money out of a fund. You should never put money in a fund that charges either type of load. It's an unnecessary and extraordinarily high expense (often around 5%). Funds that charge loads will tell you that their funds perform better, but it's not true. They perform worse, in part because investors lose so much money on the fees. So, like the name suggests, a load weighs your investment down and should be avoided.

Don't ignore personal risk tolerance. How much money could you comfortably lose? In order to invest successfully over the long term, you need to put your money in a good fund and keep it there, in good times and in bad. If you invest in a fund that's really aggressive and you lose a third of your money, will you panic and pull everything out? That's what many people do, and that's why they are not successful investors. However, if they had chosen a fund that would not likely ever lose more than 15% in a year, they might not ever take their money out, which would give them a higher return over a period of many years. It would probably not give them as high a return as someone with a higher risk tolerance, but it would give them their highest personal return. Just because you've read that young investors should put 80% of their money into the stock market because they have time to weather the ups and downs of the stock market doesn't mean that this strategy is really the best choice for everyone in that demographic. Likewise, if you're 55, you're likely to read that you should choose more conservative investments, but if you're not planning to use your investment money until you're at least 65, you can probably still afford to invest it pretty aggressively. You won't need to access your entire nest egg the day you retire, after all, so even if the chips are down when you need to start selling off some of your investments, they'll be back up again at some point.

As you gain a deeper understanding of mutual funds and investing, there are other factors you will want to consider as well, such as fund management, fund style, and any of the other myriad fund characteristics you can evaluate on sites like Morningstar. However, for now, focusing on these three key areas will get you off to a good start.

Disclaimer: As always, please remember that I am not a certified financial professional, and while I try my best to give sound advice, you should always do your own research and consult a professional you trust before making any decisions about your money.

Photo by Icy Blue