How do you choose the right mutual fund for you?

E*TRADE Securities, in collaboration with Capital Group, home of American Funds®

08/18/20

Choosing a mutual fund can feel overwhelming. After all, there are thousands of funds you could buy. So where to begin?

First, it’s important to know that every fund starts with a mission or investment goal called an objective. Some focus on the stocks of large U.S. companies, for example, while others might search for opportunities in international bonds. For almost any type of investment you can think of, there’s probably a mutual fund that invests in it.

When a fund is actively managed, each investment is carefully chosen and monitored by professional managers whose careers are devoted to researching investments and market trends. They can buy or sell investments depending on market conditions.

Index funds, on the other hand, aim to track (i.e., closely match) the investments and performance of a market index such as the S&P 500. When the index is up the fund goes up with it, but when the index is down the fund can fall just as far.

Types of mutual funds

There are many types of mutual funds that you can use to start investing. Funds are organized into categories that are based on a range of factors, such as the kinds of assets the fund invests in, the fund’s objectives and its investing strategy. These will be outlined in the fund’s prospectus. A fund’s category and specific strategy matter a great deal because each category has a different risk profile. You can choose a fund based on how it fits with your overall investment strategy.

A mutual fund could include many types of investments, or asset classes. Here are the three most common:

  • Stock funds invest in company stocks, also known as equities. Stocks typically carry a greater amount of risk than bonds, since share values go up and down with a company’s profits and losses, as well as investor confidence in the company.
  • Bond funds hold less volatile investments like Treasury bonds, municipal bonds or corporate bonds. These are called “fixed income” investments, and they are generally less risky than stocks. But they’re also typically less likely to grow as much.
  • Money market funds invest in short-term bonds and cash-like investments. These may be the least risky, but their investors don’t expect big returns.

These are the broadest categories. There are also funds that invest in a combination of stocks, bonds or cash to provide a level of diversification. Some even invest in other mutual funds. These “funds of funds” go by names like “asset allocation funds” or “target date funds.” You may be familiar with target date funds because they are often the default option in an employer’s retirement plan. In that case, they're designed to adjust the mix of investments as you move closer to the date you plan to retire.

Finding the right mix

Even by itself, a single mutual fund provides a certain level of diversification. A stock fund, for instance, can be invested in many different companies. But it’s still invested in just one asset class (stocks). A balanced portfolio can provide diversification on many levels: stocks and bonds, large and small companies, domestic and international companies, corporate and municipal bonds, and so on. Depending on your goals and circumstances, you may need to choose one or several funds to achieve a truly diversified portfolio.

What to read next...

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Learn about portfolio rebalancing, an important step in managing a portfolio to keep its asset allocation aligned with your investing strategy.

Mutual funds qualify for special treatment under the tax law. For example, mutual funds pay dividends that may include long-term capital gain or tax-exempt interest. Read this article to learn more about how mutual funds and taxes work.

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