How to choose a mutual fund

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Choosing mutual fund investments from the thousands available can be daunting. Here are some steps experts recommend you consider when selecting investments.

Assess your investment objectives

The first step in the selection process is to formulate your investment objectives and identify your time frame. For example, you may plan to buy a new house in three years, to invest for your children's college education in 15 years, or to fund your retirement in 30 years.
Generally speaking, the longer your time horizon, the greater your tolerance for risk could be. If you have an investment time frame of more than 10 years, you may be able to position yourself for higher earning potential over the long term by investing more aggressively in growth-oriented stocks. On the other hand, if you know that you will need the money in less than five years, you may decide to allocate your portfolio to more conservative, income-producing securities such as high-dividend stocks and short-term investment-grade bonds.1

Match your goals with funds' investment objectives

The next step is to identify the types of mutual funds that match your investment goals and risk tolerance. Don't be confused by the seemingly endless differentiation of the mutual fund industry. Most funds can be assigned to one of a few large groups depending on the kinds of securities they hold.
Stock funds, for example, might be categorized as broadly diversified, or sub-grouped according to attributes such as the size of the companies they focus on. Bond funds might similarly represent the bond market in aggregate or focus on readily identifiable bond types such as Treasuries and mortgage bonds. Each group of funds can be categorized further by risk level, such as above-average risk, average risk, or below-average risk.
Information sources such as Standard & Poor's, Morningstar, Lipper Analytical Services, and Value Line are available online and at most local libraries and can help you understand mutual fund investment objectives, financial performance and risk levels. Standard & Poor's, for instance, arranges U.S. stock funds into five major groups, providing for each fund investment style, performance and risk analysis, and an overall risk-adjusted rating in relation to other funds in the same category.

Examine individual mutual funds

Once you have identified the fund categories that seem appropriate to your investment objectives, you will want to take a close look at individual funds in each of the categories. You can do this by reviewing the prospectus for each fund, which is available on the fund provider's website or through your financial advisor. The prospectus details the fund's performance, investment objective, types of securities it invests in and the risks these investments involve. A prospectus of an aggressive growth fund may tell you, for example, that the fund invests in small and often volatile stocks and that the fund involves above-average risk. You should read the prospectus carefully before investing.
When analyzing performance, remember that your time frame, with an appropriate level of risk, is the bottom line. So, instead of focusing on the funds' latest performance only, you might want to consider funds that provide above-average investment returns in the same fund category for the past three, five, and 10 years. Also, compare the annual percentage returns of a fund with its major benchmark index over the same period. For example, compare the performance of diversified stock funds with the S&P 500 stock index. Note that, unlike mutual funds, indices are not managed and individuals cannot directly invest in an index.
It is also important to remember that past performance is not a guarantee of future results.
While performance over a period of time is usually an important factor, it is not the only consideration. Be sure to look at the fund's investment policies to determine your comfort level with the securities in which it invests. Also consider the consistency of fund management — that is, what is the frequency of manager turnover? And, understand the fees and expenses that funds charge investors. Everything else being equal, lower total fees and expenses may result in higher returns.

Buying mutual fund shares

You can buy mutual fund shares through a broker or directly from a mutual fund company. To buy funds through a broker, you normally have to pay a commission. If you are comfortable with making your choices with less guidance, you may have the option of buying shares directly from a fund company via its website. Finally, first-time mutual fund investors are often advised to start small, and all investors should consider diversification, which may lower risk.2

Footnote 1 These allocations are presented only as examples and are not intended as investment advice. Please consult a financial advisor if you have questions about these examples and how they relate to your own financial situation. The investor profile is hypothetical.

Footnote 2 Diversification does not ensure a profit or protect against loss in declining markets.

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