Once you have your retirement account in place -- whether you're funding an IRA, Roth IRA, 401(k) or other defined-contribution plan -- the next step is filling it with investments. You need to allocate your money based on your goals, and when you want to reach them.
For most people, the goal is retirement. But it could be 10, 20, 30 or 40 years before you're ready to knock on that door. No matter what your time horizon is, mutual funds are one of the best investment tools to help you get there.
A mutual fund allows you to buy into a basket of investments. Instead of investing in particular companies, as you would if you were picking stocks, you're buying a wide variety of not only stocks, but also bonds and even fixed-income investments like money markets. The idea is that you're taking a more diversified risk -- if one area performs poorly, the others are expected to balance it out. Of course, that doesn't always happen (as we saw during 2008), but in most cases, it's a pretty safe bet.
So how do you choose the best fund for you? Here's a quick guide.
• Decide what kind of fund you want. If you have only a few years before you need the investment, the priority is protecting your money, and you can do that with a money market mutual fund or a short-term bond fund. A money market mutual fund is different than the money market offered by your local bank, because it's an investment product and is not FDIC insured. It does, however, come with a promise to keep your principal value stable. If you're more than five years away from your goal, you can pick a fund that holds stocks, like a target-date retirement fund, which takes a lot of legwork off your hands, says Christine Benz, Morningstar's (MORN) director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.
• Consider the costs. "Morningstar is often running data to look at which characteristics are predictive of good future performance, and low costs jump out as one of the most predictive factors every time," says Benz. How do you know if a fund is low-cost? She says that in general, there's no reason to spend more than 1% a year for any type of fund. For bond funds, because the return is typically low, you should set the threshold a bit lower, at .75%. Finally, with money market mutual funds, try to stay under .5%, because your return is much lower – often less than 2%. You don't want to give away more than a quarter of your earnings to expenses.
• Understand sales charges, or loads. If you're buying the fund through a broker, he or she should explain what the costs are and how they are assessed. Some charge you a commission at the time of purchase, and that amount comes off the top of your investment. Others don't charge at the outset, but charge you a slightly higher rate from year to year, and then assess a fee when you sell. And still others don't have a commission to buy or sell at all, but charge fairly high fees year in and year out, often approaching 1.75%. If you don't plan to hold the fund for long, the last option is probably best for you; otherwise consider the first two. Remember that you can often also buy funds from a planner who deals only in no-load funds and charges you only for the advice.
• Look at performance. A fund's past performance is far from a surefire indicator of the future, but it's certainly worth looking at. The shareholder materials will give you the fund's past returns, as well as how they compare to the market; Morningstar also rates funds on its website. The longer the fund has been around, the better, because you'll have a wider stretch to see how it has behaved in the past. "2008 and 2009 give you a really good lens to evaluate a funds performance and what kind of fund you're dealing with," says Benz. "2008 was the mother of all stress tests, and if a fund performed terribly, it's a good indication that it's a higher-risk fund. If it held up well relative to its peers, it's probably a fund that pays attention to limiting losses. In 2009, we saw the polar opposite -- high-risk strategies did really well." If you're risk-adverse, and you're in a really aggressive fund, you won't be able to sleep at night, so this is an important thing to consider.
• Evaluate the big picture. Benz says funds have a lot of leeway in terms of how they name themselves and how they invest, and the two don't necessarily correlate. So, you need to do a little of your own due diligence and make sure the fund is investing the way you want it to. Morningstar has a Style Box tool that shows you the investment style of mutual funds -- whether they are investing in large companies, small companies, value, growth, etc. "Knowing this information will help you balance the rest of your portfolio and be sure that you're adequately diversified," says Benz.