A mutual fund is a type of investment product where the funds of many investors are pooled into an investment product. The fund then focuses on the use of those assets on investing in a group of assets to reach the fund’s investment goals. There are many different types of mutual funds available. For some investors, this vast universe of available products may seem overwhelming.
How To Pick A Good Mutual Fund
Identifying Goals and Risk Tolerance
Before investing in any fund, you must first identify your goals for the investment. Is your objective long-term capital gains, or is current income more important? Will the money be used to pay for college expenses, or to fund a retirement that’s decades away? Identifying a goal is an essential step in whittling down the universe of more than 8,000 mutual funds available to investors.
You should also consider personal risk tolerance. Can you accept dramatic swings in portfolio value? Or, is a more conservative investment more suitable? Risk and return are directly proportional, so you must balance your desire for returns against your ability to tolerate risk.
Finally, the desired time horizon must be addressed. How long would you like to hold the investment? Do you anticipate any liquidity concerns in the near future? Mutual funds have sales charges, and that can take a big bite out of your return in the short run. To mitigate the impact of these charges, an investment horizon of at least five years is ideal.
Style and Fund Type
The primary goal for growth funds is capital appreciation. If you plan to invest to meet a long-term need and can handle a fair amount of risk and volatility, a long-term capital appreciation fund may be a good choice. These funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be risky in nature. Given the higher level of risk, they offer the potential for greater returns over time. The time frame for holding this type of mutual fund should be five years or more.
Growth and capital appreciation funds generally do not pay any dividends. If you need current income from your portfolio, then an income fund may be a better choice. These funds usually buy bonds and other debt instruments that pay interest regularly. Government bonds and corporate debt are two of the more common holdings in an income fund. Bond funds often narrow their scope in terms of the category of bonds they hold. Funds may also differentiate themselves by time horizons, such as short, medium, or long term.
These funds often have significantly less volatility, depending on the type of bonds in the portfolio. Bond funds often have a low or negative correlation with the stock market. You can, therefore, use them to diversify the holdings in your stock portfolio.
However, bond funds carry risk despite their lower volatility. These include:
Interest rate risk is the sensitivity of bond prices to changes in interest rates. When interest rates go up, bond prices go down.
Credit risk is the possibility that an issuer could have its credit rating lowered. This risk adversely impacts the price of the bonds.
Default risk is the possibility that the bond issuer defaults on its debt obligations.
Prepayment risk is the risk of the bondholder paying off the bond principal early to take advantage of reissuing its debt at a lower interest rate. Investors are likely to be unable to reinvest and receive the same interest rate.
However, you may want to include bond funds for at least a portion of your portfolio for diversification purposes, even with these risks.
Of course, there are times when an investor has a long-term need but is unwilling or unable to assume the substantial risk. A balanced fund, which invests in both stocks and bonds, could be the best alternative in this case.
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