Your Guide to Investing in Mutual Funds

Each individual mutual fund within a family of funds has a specific investment goal and invests only in securities that reflect those specific goals. The individual funds are sold at a price that fluctuates daily- just like the price of an individual share of stock fluctuates from day to day. However, unlike a share of common stock, the price of a mutual fund share doesn't change throughout the day. It only updates once per day, at the close of market business.

Thanks to 401k plans and IRA accounts, a large percentage of Americans are already owners of mutual funds. But mutual funds can be purchased for various reasons, including direct purchase of funds for individual investment purposes, for college savings, or for reaching some other financial goal. Selecting mutual funds through a company sponsored 401K plan usually involves a limited choice of funds, since the majority of companies offer funds from only one or two mutual fund companies. For those looking to buy a mutual fund directly, the choices can become more confusing due to the large number of funds available for purchase.

WHAT TO LOOK FOR WHEN SHOPPING FOR A MUTUAL FUND

Mutual fund investing can seem complicated. But a quick rundown of some important questions should get an investor on the right track toward purchasing the right fund. Questions to consider include:

• What are your investment goals? Are you trying to save for a short term purchase? Is your goal a college savings? Is the investment intended for retirement? How long before you will need to withdraw the money? The answers to these and other, similar questions will have a direct impact on the selection of a specific mutual fund in which to invest.
• How much risk are you willing to accept? Mutual funds are, by nature, less risky than owning direct shares of common stock. But there is still some risk present, just like with all investments. How much risk is acceptable? It will depend on your own level of risk aversion and your own financial needs. If the money will be needed and withdrawn in a short period of time, then it makes sense to seek out less risky mutual fund investments. If the funds will not be needed for a long period of time (five years or more), then a riskier mutual fund investment might be appropriate.
• What about mutual fund fees? Every mutual fund company deducts a percentage of a fund's value to cover management expenses, but many funds also charge other fees. Most mutual funds are offered as "No Load", which means they charge no fees up front when you invest in the fund. Others charge a fee that is deducted immediately from your investment dollars; lowering the value of your asset and creating a negative return on investment at the beginning. Some mutual fund companies also charge 12b-1 fees, which are hidden fees deducted to pay for advertising, brokerage, and other costs.
• How has the fund performed over the past several years? Past performance is no guarantee of future performance, but the rate of return from the past several years is usually a strong indication of a mutual fund's direction and it should be taken seriously. A fund with a solid record of steady, ten percent gains for the past ten years, for example, is very likely to outperform another fund with a steady performance of only five percent gains for the past ten years.
• Are you willing to give up the option of selecting your own stocks? Mutual funds are managed by a team of financial professionals who collect money from investors and purchase shares of companies based on the investment goals of a particular fund and the personal opinion of the fund's managers. Thus, an individual investor has no say in what securities a mutual fund manager chooses to purchase. It is entirely up to the fund management to make that decision. You, the investor, surrender the option to select your own portfolio of common stock when you decide to invest in a mutual fund. 
• Are you prepared for the possibility of taxable income? Not only are taxes due when you sell (assuming a capital gain was made) a mutual fund, taxes are also due each time a mutual fund company declares a capital gain distribution, regardless of whether the investor decides to withdraw the money or reinvest. The greater a mutual fund's turnover of assets (the more frequently the management buys and sells securities), the greater the chance for a large capital gain distribution. These are taxed as ordinary income, and they present one definite disadvantage to owning a mutual fund vs. a share of common stock. Specialty funds, common stock growth funds, etc., often experience high asset turnover and thus are likely to cost the investor more in taxes because they will likely distribute capital gain distributions at year end. Index funds (those that buy stocks in a specific index, like the S&P 500), on the other hand, do not buy and sell as frequently and as a result have few capital gains distributions and thus cost their investors less in taxes each year.

MUTUAL FUND DOs AND DON'Ts

Before buying a fund, investors should:

• Always obtain a Prospectus - A Prospectus is an informational brochure that describes the objectives of the mutual fund, its investment strategies, its performance history, and other relevant information.
• Research the funds performance - The performance information in the prospectus is a good place to start, but this is only the beginning. It is equally important to obtain performance information on other mutual funds with a similar investment strategy and risk level for comparison purposes. A desired mutual fund might offer what sounds like a promising level of annualized return, only to be outranked by other, similar mutual funds. Comparison research is the only way to know for certain how one mutual fund stacks up against the rest.
• Don't fall into the trap that says "bigger is better" - There are many large, well- established mutual funds that have been selling shares to the public for decades. These funds offer a certain degree of comfort, due to their years of investment expertise. But just because one mutual fund family is larger (i.e.- contains more invested assets) than another doesn't necessarily mean its funds are going to outperform those in the same peer group. In fact, more than likely, the opposite is the case. The best performing funds in any given year are often those offered by lesser- known mutual fund families.
• Don't assume that a fund can't have a bad year - Mutual funds, due to their diversified nature, are safer than owning common stock shares in a single company. But the safety of diversification is not absolute. No matter how safe a fund might seem, there is still a chance that it could show negative return for a given year. Even funds that have a high rating by the different mutual fund rating companies can still experience losses.
• Be wary of investments in specialty funds and in foreign funds - Specialty funds are those that concentrate on a specific industry, like a "Health Services" fund or a "Telecommunications" fund. These specialized funds have a certain appeal to many investors. If a segment of the economy seems to be outperforming the rest, then these specialty funds can produce some very handsome rates of return. However, the increased probability for a good year also means there is a greater chance that the returns will head south. In a nutshell, specialty funds are riskier, and with added risk comes greater price volatility and greater chances for both gains and losses. Foreign mutual funds are no different and, in fact, they often rank as the riskiest funds of all. These foreign mutual funds place the shareholders money into businesses in a specific foreign country or region of the world. This brings with it all sorts of additional risks, like political risk and foreign exchange risk. Investors need to be fully aware of the risks associated with these types of investments before they open an account.

WHAT ARE THE BEST AND/OR LARGEST MUTUAL FUNDS?

Mutual funds are considered "good", "bad", or "mediocre" based on many different criteria. It is best to consult a financial advisor or someone you trust about the best investments to make. You can also read mutual fund reviews, spend time watching TV shows specializing in finance, or read material about investing. Check out some of the most popular mutual fund companies and mutual fund websites below.

Popular mutual fund companies include:

• Fidelity Investments
• Vanguard
• T. Rowe Price
• American Century
• Janus Fund
• John Hancock
• Dreyfus
• USAA
• Oppenheimer
• Franklin
• Royce
• Putnam

Popular mutual fund websites

Morningstar - One of the best known names in investment evaluation, Morningstar offers ratings of all publicly traded mutual funds as well as performance rankings of mutual funds across various categories. With the individual mutual funds, Morningstar assigns a rating from one to five stars based on the fund's performance relative to other, similar mutual funds and compared to a common stock index comprised of companies similar to those in which the mutual fund invests. 

Lipper - Lipper is a wholly- owned subsidiary of Reuters, Inc. This company offers mutual fund ranking/ratings based on official research of all families of mutual funds. Not only does Lipper research the average rates of return for all mutual funds, it also publishes special reports that can be very useful to mutual fund asset managers and individual investors alike. The only disadvantage of Lipper is that it requires registration with the site in order to view the ratings and reports.

WinningInvesting.com - This online service isn't a mutual fund rating business, like the two companies listed above. Rather, Winning Investing is an educational site designed to help individuals learn more about investing. It includes free tutorials, basic training on the process of investment selection and management, links to other investment web services, and a free newsletter.

Marketwatch.com - Market Watch is a general- purpose financial web service with up- to- date news about business and personal finance, tools and research tips, and a special link for mutual funds that includes a fund finder, a fund comparison tool, and a recap of the top mutual fund gainers and losers for the past year.

FINAL THOUGHTS

Mutual funds are a popular investment tool and millions of Americans own mutual funds as part of their retirement plans.

Many people like mutual fund investing for various reasons, but chief among them is the reduced level of stress when compared to owning common stock. Generally speaking, mutual funds are less risky than owning direct shares of common stock and the reason is obvious: With a mutual fund, an investor's money is divided among hundreds of companies, and is therefore diversified and relatively safe. This doesn't mean that a mutual fund is devoid of risk, however, and it doesn't mean that a mutual fund cannot lose value from one year to the next. What it does mean is that a mutual fund will almost certainly be less price volatile than an investment of common stock in the shares of one company. But in exchange for this added safety, an investor needs to keep in mind that an investment in a mutual fund company is not likely to produce significant short term gains. Common stock has the potential to gain or lose ten percent or more of its value in a matter of days or even hours, in some instances. A mutual fund, on the other hand, is far less likely to see its price grow or shrink by any significant percentage in a short period of time.

Many people are drawn to mutual funds that are large in size and offer familiar names.

In the world of mutual funds, however, larger is not necessarily better. A mutual fund company with billions of dollars in assets does offer a greater degree of security compared to a smaller company, since a larger company has more cash, more ways to diversify, and is thus less likely to go bankrupt. But larger mutual fund companies are not necessarily better performers. In fact, most of the highest performing individual mutual funds are offered by lesser- known mutual fund companies. 

Mutual fund ownership is widespread

  Mostindividual investors have several thousand dollars invested in mutual funds through their company- sponsored 401K plan or their own Individual Retirement Account. But mutual funds are offered for sale to anyone, regardless of whether or not they are part of a retirement plan. Any adult can contact a mutual fund company, request a prospectus, and open an account. Conducting research is the first step toward mutual fund investment, and the advent of the internet has made this process easier than ever before.

Many different investment vehicles exist to help individual investors meet their financial goals.

Mutual funds rank among the safest and easiest investments to purchase and it isn't surprising that their popularity has soared in the past couple of decades. A novice investor could be overwhelmed at first by the different options available with mutual funds, the various tax consequences, the different ways to fund the investment, and the many different fees and other cost considerations. But education on mutual fund investing is readily available and with a little bit of effort, uninitiated investors can quickly learn the ins and outs of mutual fund investing and be well on their way to meeting important financial goals.

SOURCES

Morningstar.com, Marketwatch.com, Fool.com, Lipperweb.com, Winninginvesting.com