Whether you are just starting out or are trying to invest more for retirement, chances are you will invest in mutual funds. After all, with a mutual fund, you get exposure to different industries without having to become an individual stock picker. But when it comes to mutual funds, not all of them are created equally. Choose the wrong one and you may face exorbitant fees, or worse, investment areas that erode your investment returns. With that mind, here’s a look at four mistakes to avoid when choosing a mutual fund for an investment.
Paying Too Much in Fees
When it comes to mutual funds, investors are going to pay different fees depending on the fund they go with. Actively managed mutual funds or ones that have a fund manager who picks the stocks to include are going to charge more than passive ones, such as an index mutual fund. But that’s not the only difference in terms of fees. Some mutual funds pay brokers a commission for selling their product to investors. That commission, known as a front-end load, can be up to 5% of invested assets and is charged upfront.
A back-end load mutual fund is a fee you pay when you sell the fund. The longer you hold on to it the less it will be. A no-load fund has no commission associated with buying or selling the fund and is often a good choice for mutual fund investors who want to minimize the fees they have to pay. Investors who don’t pay attention to fees could see their returns diminished as a result, even with a mutual fund.
Chasing Past Performance
Often investors will chase past performance in hopes of seeing the same returns. But past performance doesn’t mean future performance, and while a fund did well one year or even over five years, that doesn’t mean it will continue to do so. Far too often investors will choose their mutual funds based on performance without giving much thought to what the fund invests in and whether or not the exposure matches their risk tolerance and time horizon for investing. While past performance can help narrow the playing field it shouldn’t be the only reason to choose a particular mutual fund.
Not Paying Attention to the Tax Implications
While many investors will use mutual funds with their company-sponsored retirement accounts, they will also invest in mutual funds outside of retirement accounts, which could create a tax event, if they aren't careful. These tax events occur because if an investor chooses an actively managed mutual fund that has a high turnover rate, the investor could be on the hook for any gains. Typically, the mutual funds with higher turnover rates are going to generate more tax events of which investors have to be aware. (Read more about when to sell a mutual fund.)
Not Being Aware of Overlapping or Redundant Investments
Many people think they can choose a mutual fund, invest in it and then forget about it without giving too much thought to the underlying investments in the fund. If you own only one mutual fund this may be acceptable, but if you have your investments spread out over different funds to get diversification then you are going to have to do some homework.
After all, you don’t want to hold the same investments in multiple mutual funds. The whole idea is to be diversified in different asset classes and industries, and if your mutual funds all hold the same stocks and/or bonds, then you aren’t diversified. A possible outcome is that if the market tanks you are going to be positioned for a bigger blow without having your investments spread out.
The Bottom Line
Mutual funds are a good way for regular investors to build wealth, but they aren’t completely risk-free. In order to ensure you are choosing the right mutual fund, investors have to pay attention to the fees, turnover rate, investment holdings, and performance.