1. What exactly is a mutual fund?
A mutual fund pools money from hundreds and thousands of investors to
construct a portfolio of stocks, bonds, real estate, or other
securities, according to its charter. Each investor in the fund gets
a slice of the total pie.
2. Mutual funds make it easy to diversify.
Most funds require a minimum investment of only a few thousand
dollars, enabling investors to construct a diversified portfolio much
more cheaply than they could on their own.
3. There are many kinds of stock funds.
The number of categories is dizzying. Some examples: growth funds,
which buy shares of burgeoning companies; sector funds, which buy
shares of companies in a particular sector, such as technology or
healthcare; and index funds, which buy shares of every stock in a
particular index, such as the S&P 500.
4. Bond funds come in many different flavors too.
There are bond funds for every taste. If you want safe investments,
consider government bond funds; if you're willing to gamble on high
risk investments, try high-yield (aka junk) bond funds; and if you
want to keep down your tax bill, try municipal bond funds.
5. Returns aren't everything -- also consider the risk taken
to achieve those returns.
Before buying a fund, look at how risky its investments are. Can you
tolerate big market swings for a shot at higher returns? If not,
stick with low-risk funds. To assess risk level, check these three
factors: the fund's biggest quarterly loss, which will help you brace
for the worst; beta, which measures a fund's volatility against the
S&P 500; and standard deviation, which shows how much a fund bounces
around its average returns.
6. Low expenses are crucial.
In order to cover their expenses -- and to make a profit -- funds
charge a percentage of total assets. At no more than a few percentage
points, expenses may not sound substantial, but they create a serious
drag on performance.
7. Taxes take a big bite out of performance.
Even if you don't sell your fund shares, you could still end up stuck
with a big tax bite. If a fund owns dividend-paying stocks, or if a
fund manager sells some big winners, shareholders will owe their
share of Uncle Sam's bill. Tax-efficient funds avoid rapid trading
(and high short-term capital gains taxes) and match winning trades
with losing trades.
8. Don't chase winners.
Funds that rank very highly over one period rarely finish on top in
later ones. When choosing a fund, look for consistent long-term
results and low operating expenses.
9. Index funds should be a core component of your portfolio.
Index funds track the performance of market benchmarks, such as the
S&P 500. Such "passive" funds offer a number of advantages over
"active" funds: Index funds tend to charge lower expenses and be more
tax efficient, and there's no risk the fund manager will make sudden
changes that throw off your portfolio's allocation.
10. Don't be too quick to dump a fund.
Any fund can -- and probably will -- have an off year. Though you may
be tempted to sell a losing fund, first check to see whether it has
trailed comparable funds for more than two years. If it hasn't, sit
tight. But if earnings have been consistently below par, it may be
time to move on.
NEXT: What is a fund?