Fred Bennett of Pasadena knew exactly what he wanted when he first started investing in mutual funds. Tired of paying high income taxes, he was looking for a fund that provided him with safe, tax-free income. He narrowed his search to funds investing in tax-free government bonds.
However, Bennett is unusual. Industry experts say many investors have never stopped to consider their own investment goals and that makes picking a mutual fund difficult.
That's because each mutual fund has investment goals of its own. Wise investors match their objectives to the objectives of the fund to come up with returns and risks that they're comfortable with.
Those who haven't formulated their own investment strategy must think through their finances before they start shopping. The main items individuals need to consider are their age, their obligations--debts, dependents--their income and their investment horizons.
The answers to these questions will largely determine how much risk you're willing and able to take. They'll also determine when you need your investments to pay off. This is important because certain investments do well over time but are volatile in the short run. If you have a relatively short investment horizon, you might want to avoid investments in many types of stock funds, for example.
Meanwhile, if you are investing for retirement and you're in your 30s or 40s, you would be foolish to invest solely in bonds. The payoffs are lackluster over time, particularly when compared to more volatile investments such as growth stocks.
Remember, though, that you probably have more than one financial goal. For instance, it's likely that one family will invest to create a nest egg for retirement, buy a new home and, perhaps, pay for a child's education. Where the child's college fund may be needed in five years, the retirement fund may not be needed for another 20. And you might want the money for the home at a moment's notice.
You can balance all these goals and still invest almost solely in mutual funds. But only if you spread your investments among several funds. It is wise to diversify even when investing for a single purpose. Diversification simply reduces your risks, and since many mutual funds have entry limitations as low as $100, even those with small amounts to invest can buy several funds if they want to.
"The nice thing about mutual funds is you can own more than one," said A. Michael Lipper, president of Lipper Analytical Services, a New York-based company that studies mutual fund performance. "And you are probably better off choosing several."
Once you have considered your investment goals, you can start to review the mutual funds that have similar goals. The Investment Company Institute, a Washington trade group for the mutual fund industry, divides fund objectives into 22 broad categories, which each offer different risks and rewards.
These categories include aggressive growth, balanced funds, corporate bond funds, flexible portfolio, growth and income, income and equity, money market, global equity and global bond funds. The trade group provides short explanations of each moniker in its annual Directory of Mutual Funds.
This directory can be helpful to investors who need basic information about fund objectives, investment restrictions and fees. The 1992 directory should be available in March. It can be ordered through the Investment Company Institute, PO Box 66140, Washington, D.C. 20035-6140. The cost is $5.
But this directory is just a start. It should spur you to do more investigation, probably by looking through other, more comprehensive mutual fund reports.
Possibly the best fund reports available are published by Morningstar Inc. of Chicago. These directories and performance reports are expensive, roughly $400 a pop. However, if you invest through a financial adviser, your adviser should have a copy that you can look through. Otherwise, they are often available through public libraries.
The Morningstar reports give descriptions of a fund's investment history, large holdings, management, etc. The company also ranks funds by how well they've performed and by how risky they are based on what they're trying to do.
These directories should allow you to narrow your search to just a handful of funds. Still, your research job is not through.
At this point, you should contact the fund companies and ask for a prospectus, a legal document that gives you detailed information about the fund, its background, investments, history, fees, philosophy and the like. Get ready for some heavy reading. Trudging through a prospectus is not a lot of fun, but if you hope to invest well, it's imperative.