(MONEY Magazine) – No, it's not just your imagination--mutual fund investing is getting tougher. Take something as basic as knowing what kind of fund you own. Garden variety U.S. stock fund, you say? Better check again. To juice up their returns, some domestic fund managers routinely load up on highly volatile emerging market stocks. As for that seemingly ultrasafe short-term government bond fund you own, have you peeked in a recent quarterly report to see whether it's bristling with risky derivatives? And have you added up your fund's overt and covert charges to learn how much you're really paying in expenses?

Such chores didn't seem so pressing in the 1980s and early 1990s, when even indifferently managed funds were chalking up double-digit annual returns. But after a brutal year like 1994--when many foreign bourses melted down, domestic bond prices blew up and U.S. stock markets meandered sideways--smart investors now realize that they have to do their homework to make money with funds.

To help you do just that, we offer seven timely guidelines that will enable you to master the new complexities of fund investing-and make the most of what is shaping up as a strong year for investors. In the first three months alone, Standard & Poor's 500-stock index returned 9.7%, after gaining only 1.3% in all of 1994. Moreover, Hugh Johnson, chief investment strategist at the money-management firm First Albany, believes that moderate inflation and slow-but-steady economic growth could push diversified domestic stock funds--already up 7% the first quarter of this year--to additional gains of 8% or so over the next 12 months. What's more, despite currency crises and turmoil in emerging markets, savvy investors can still ferret out international funds capable of similar returns. "As more countries move from socialism to privatization, the outlook for the global economy is the best it's ever been," says San Francisco investment adviser Kurt Brouwer. Even the downtrodden U.S. bond market is looking up. Federal Reserve chairman Alan Greenspan's seven inflation-fighting hikes in short-term rates over the past 15 months should eventually send long-term-bond rates drifting down, triggering a surge in bond fund profits.

Naturally, you want to reap your share of these gains-without repeating last year's costly mistakes. That's where this Money Guide comes in. It is designed to help you assemble a portfolio of funds that can stand up to a variety of market conditions, deliver consistent above-average returns and bring you within reach of your financial goals.

We get you started by explaining in this story the seven essential rules you must follow to invest successfully in funds today.

1

FOCUS ON YOUR GOALS AND RISK TOLERANCE.

In the booming markets of the '80s and early '90s, almost any haphazard collection of funds could make money. In today's tougher investing climate, however, some of your funds may be riskier than you originally thought--or may no longer suit your goals. So re-evaluate all your funds now to make sure they still jibe with your objectives and willingness to take risks.

Let's say, for example, that you are building a portfolio for retirement in 20 years. In that case, lighten up on government bond funds, which, as last year's 4% losses showed, are far riskier than many investors once believed. In fact, investment strategists suggest you shouldn't put more than 25% of your money in such funds. Instead, load up on stock funds. Despite occasional volatility, only equities can provide the inflation-beating growth you need to pile up enough money to retire in comfort. (For more on dividing your money among different types of funds, see "Finding the Right Mix" on page 34.)

In addition, realistically determine how much risk you can tolerate. "The odds are that we will have another bear market sometime in the next five years," says Craig Litman, a San Francisco investment adviser and co-editor of the newsletter No-Load Fund Analyst ($195 a year; 800-776-9555). "Ask yourself how you would react if your fund's value went down 25% or more--and stayed there for several years." If you would probably sell, exchange your most volatile funds for steadier performers. (The listings beginning on page 62 give the risk levels of 2,193 stock and bond funds.)

2

FINE-TUNE YOUR PORTFOLIO MIX.

The strategy that pros call asset allocation--spreading your money among stocks, bonds and other assets to reduce your portfolio's overall risk without giving up too much in annual returns--actually worked better last year than many investors think. True, virtually every category of funds lost money, but some categories fell more than others. For example, foreign regional funds, hit hard by the Mexican peso's 31% plunge, lost 6.7%, while domestic growth and income portfolios slipped only 0.9%. Thus investors who held both foreign and domestic funds lost less money than they might have otherwise. "The right asset mix doesn't guarantee you won't lose money in any given year," explains Pittsburgh investment adviser Roger Gibson. "Over the long term, however, a diversified fund portfolio will reduce volatility while earning impressive returns."

To reap diversification's benefits, be sure to divide your portfolio among funds that focus on different market segments--large vs. small stocks, for example--and that follow both value and growth investing styles. Value managers look for bargain-priced stocks that are likely to do well over the long term; growth managers favor companies with rapidly increasing earnings. While value did best from 1992 through last July, many pros predict that growth will continue to excel for the next two years or so.

Unfortunately, warns Catherine Voss Sanders, editor of the biweekly newsletter Morningstar Mutual Funds ($395 a year; 800-876-5005), "investing styles go in and out of favor unexpectedly. To be sure you don't miss these pendulum swings, you should hold both styles in your portfolio." (The tables that start on page 62 describe the investing styles of 1,340 stock funds.)

3

MAKE SURE YOUR FUNDS AREN'T IMPOSTORS.

You can't simply rely on a fund's name or investment category to tell you how its manager actually invests. One reason: No matter how innocuous-sounding the fund name, the manager may stray into alarmingly risky territory to post eye-catching returns. Last year, for example, thousands of income investors in two supposedly safe short-term bond funds, Piper Jaffray Institutional Government and Paine Webber Short-Term U.S. Government, were hit with losses of 29% and 5% respectively, because the managers had stocked up on highly volatile mortgage-backed derivatives.

Equity funds can also have the investing equivalent of a split personality. For example, although its name obviously suggests that it pursues a value strategy, Dean Witter American Value actually invests for growth. So anyone who put money in the fund from 1992 to 1994, when value funds scored 7.7% gains, would have been disappointed by the fund's 4.7% return. Similarly, Berger 101, ostensibly a domestic equity fund, held more than a 30% stake in foreign stocks last year, which contributed to its 9.1% loss.

To get a fix on how a fund actually invests, first read its prospectus. For instance, Berger 101's prospectus lets the manager stash any amount of the fund's assets in foreign stocks. Then, regularly monitor the fund's holdings by examining its quarterly report, which lists every security in the portfolio. (For more on researching questions about funds, see "The Best Electronic Fund Sources" on page 8.)

4

DON'T FALL FOR FLASHES IN THE PAN.

"One of the biggest mistakes investors make is buying a fund just because it's topped the performance charts over a short period," says investment adviser Litman. Bad move. Funds that climb to the top of the charts in one year often crash and burn the next. That's because blazing short-term performance is usually fueled not by the fund manager's skill but by a big bet on a hot industry sector that is about to cool, or on an investing style that has peaked and is about to fall out of favor. Fidelity Latin America, for instance, rocketed to a 62.1% gain in 1993. Investors who chased that performance, however, ended up with cold tamales last year, as sinking markets in Argentina, China and Mexico pounded the fund for a 23.2% loss.

On the other hand, you shouldn't ignore past performance. At the very least, it can shed light on the fund's volatility. (For more on evaluating past performance, see "Past Performance Does Matter" on page 20.) Value Line Mutual Fund Survey editor Steve Savage recommends homing in on funds that have ranked consistently in the top half of their categories for the past five years or so, which is long enough to show how well the funds fare in bad markets. "You won't often see the names of these steady funds in newspaper listings of top 10 performers," he observes. "But if you hold them for five years or more, you will do superbly." Savage warns, however, that you must make sure that the manager responsible for past superior gains is still at the fund's helm.

5

WATCH OUT FOR WALLET-WHACKING FEES.

When funds were routinely churning out double-digit returns in the '80s, most investors didn't mind paying bloated annual expenses. But in times like last year, when even half a percentage point represented a sizable portion of a typical fund's gain or loss, it pays to make sure a fund's expense ratio doesn't exceed the category average. (Our fund listings beginning on page 62 can help you compare funds' annual expenses.)

In the case of bond funds, high expenses may lead a manager to take on too many risks. Says Morningstar's Voss Sanders: "Few fixed-income managers can beat the averages, and those saddled with high expenses are tempted to take more risk to overcome the drag of their fees." So, stick with bond funds that charge no more than the average 0.89% expense ratio.

Recent studies by the Securities and Exchange Commission and Princeton economics professor Burton Malkiel make an equally compelling case for opting for low-expense stock funds as well. Their research shows that for every percentage point the average stock fund spends on expenses, its return falls 1.9 percentage points. That's because those higher expenses are typically caused by frequent trading of investments, which tends to reduce returns. Since you aren't buying better performance by paying higher fees, stick with no-load equity funds that levy no more than the 1.5% average annual expense ratio. (You can go to 1.7% or so for small-cap funds and 2% for internationals, because it costs managers more to research those markets.)

6

DON'T TRY TO OUTGUESS THE MARKET.

No one can consistently jump in and out of the stock market, nimbly pocketing profits and avoiding losses as prices rise and fall.

Need convincing? Consider this hypothetical example from Value Line: Two investors each put $10,000 into a typical growth-stock fund just before the October 1987 meltdown. The first panics at the market plunge and sells out, losing 27%, and sticks the remaining $7,300 into a money-market fund yielding 5%. In 1990, he moves back into a growth fund to catch the market's rise, only to bolt to a money fund again nine months later after the growth fund tumbles 11.5%. The second investor, meanwhile, sits tight in the growth fund the entire time. When they compare the value of their accounts at the end of 1994, who do you suppose fared better? For all his moves in and out, the panicky investor has only $8,916 left-a 10.8% loss. The buy-and-hold investor's account grew 84% to $18,406.

7

JUST DO IT.

Finally, don't delay investing because the market suddenly zigs or zags, or because you're paralyzed at the thought of having to choose among 7,467 stock and bond funds. Relax. As long as you follow our rules, you will do just fine. The most important thing is to get in the mar-ket early and stay there. For example, someone who begins putting away $2,000 a year at age 30 will have a whopping $272,615 by age 60, assuming a modest 9% average annual return. If that same person doesn't get started until age 35, however, she would end up with only $169,402. Bottom line: The sooner you begin investing, the better off you will be. So get going.