Hence, here is a straightforward guide that helps to combat much of the confusion that is all too often associated with buying a mutual fund.
1. What is your goal?
The first and most important question, and one that is frequently overlooked, has more to do with you than the list of mutual funds offered for purchase through your broker. The mutual fund buying process should start with the investor addressing his or her goals. This includes answering questions about your investment objectives, risk-preference, and time horizon. To make things easier, your investment objective should more or less fall into one of these three categories:
Growth – This sort of strategy aligns with younger and more risk-tolerant investors whose top priority is to increase the value of their investments over time.
Capital Preservation – This sort of strategy aligns with more conservative investors and perhaps those nearing retirement whose top priority is to safeguard their assets and ensure stability in the portfolio.
Income – This sort of strategy aligns with yield-starved investors and retirees whose top priority is to generate a meaningful current income stream from their portfolio.
Because no single investment vehicle can realistically address all three of these objectives in a balanced manner, asking about the fund objective or theme helps you understand how and where your money is going to be allocated.
2. Which fund is better?
It’s impossible to compare funds “across the board”. Mutual funds not only differ in their financial objectives but also invest in different kind of securities that reflect the ultimate objective of the fund. Thus, depending on the securities the fund is investing in, or the mix of securities chosen for a specific fund, the element of ‘risk’ varies substantially.
The fund’s objective is what the fund seeks to achieve by investing. This will determine what kind of securities the fund will buy, and in what economic sectors or countries.
For example, a fund seeking the highest possible return on capital may invest in more speculative common stocks than one seeking maximum income from dividends. The risk in the first objective is much higher than in the second.
You can see, therefore, that the amount of risk involved is directly related to the fund’s objective. Generally speaking, it can be assumed that the higher the return, the higher the risk involved.
However, mutual funds remove much of the risk from investing because they are professionally managed by fund managers with many years experience in portfolio management. For example, in common stock funds, professional managers select the investments and monitor them carefully and constantly. In addition, because of the ‘pooled’ concept inherent in funds, the element of risk is spread, thereby making funds less vulnerable to market fluctuations.
It should also be remembered that while it may be considered ‘safe’ to keep one’s savings in cash, there is always the risk that inflation will, over time, erode the value of those savings.
3. How do the rates of return offered in funds compare with savings accounts?
Generally speaking, savings accounts are the means by which banks and trust companies borrow money from the public and lend it to companies and individuals at higher rates. The financial institution makes money on the spread or the difference between the rate it pays on savings accounts and the rate it charges borrowers. A money market mutual fund, for example, lends money directly to governments, corporations, and financial institutions and all people who invest through such funds earn the higher rate. There is no middle man.
The rates of return for “non-guaranteed” investments, such as common stock funds have, over time, historically been much superior to that of a savings account with a financial institution. This is because, in a free enterprise system, investors who choose to “share” ownership of a public business by purchasing common shares are sharing in the fortunes of the business. If it does well they share profits – if it does badly there are little or no profits to share. They therefore expect, and get, a higher return for taking this risk. However, it must be borne in mind that the return on a common stock fund would not necessarily be consistent from year to year as companies do better in some periods than others.
4. How will this fund help me achieve my goals?
Each individual has short and long-term goals. Do ask the distributor/advisor how his/her recommended fund will help you achieve your goals. For example, buying a car in three years and arranging for the marriage of your children after 20 years require very different kinds of investment approaches. So lay out your goals and be firm about choosing a scheme whose tenure, investment focus and risk profile is likely to help you achieve those goals.
5. What does it cost to invest in a fund – and do I need to understand stock, bond or money markets before I invest?
Basically, all funds charge a management fee which is a percentage of the value of the assets of the fund. On average it is an annual percentage of between 1 and 2 percent. There are also the expenses of administering the fund, which are typically charged to the fund. Together these form the management expense ratio of the fund. In addition, there may be sales commissions charged on the purchase or redemption of shares which are paid to the distributing agency. Remember that commission is paid for the value-added service of investment planning provided by salespeople. The amount of commission will depend upon the size of the purchase. If you understand investment, risk factors and tax considerations, funds without sales commissions (no-load funds) may be investigated.
6. How easy is it to liquidate funds?
Most funds have their shares or units valued daily. This means that investors may purchase shares or units on any business day, and in most cases, may redeem or sell those units or shares back to the fund on any business day.
We hope this guide helped you figure out the right questions to ask before choosing a mutual fund. Mutual funds as an investment avenue have been gaining in popularity over the years, thanks to the wide range of options available and the convenience they offer. You could definitely make your million owning mutual funds. If you’re unsure, our Money Tree Strategy is the right place to start.
