Avoid these 5 Pitfalls when Buying Mutual Funds

Woman thinking about Mutual Funds

Source: V Alic

Investing in a mutual fund can be a wise investment decision, if it is a decision you make on your own. When you decide to invest in a 401k, 403b, or similar retirement plan, your money is being invested into a mutual fund so that it will grow.

You may have some choice as to what type of risk you wish to take with your money, but that simply decides what kind of mutual fund your money is going to be invested in. Aside from that, you don’t have much of a choice.

While the lack of choice when it comes to retirement plans can be considered a pitfall, many individuals are satisfied with their retirement plans because they were able to choose their degree of risk. Nonetheless, there are further pitfalls for those that invest in mutual funds just for the sake of making a profit. Knowing these pitfalls can help you make an informed investment decision.

1. There may be tax consequences

Mutual fund shareholders may receive capital gains distributions that are due to the fund selling the securities that it owns. This results in what is called a “tax drag.” An example of this tax drag is a large cap mutual fund selling shares of s stock above the purchase price.

If you are a mutual fund owner because of an IRA, 403b, 401k, or another such retirement account, you will not be taxed on the capital gain received because you’re money is secured in a tax-deferred retirement plan. If your account is taxable, it is good to focus on funds with a low-turnover, such as an index fund. There are also some more tax-efficient mutual funds that are available. If working with a financial advisor, you can speak with him or her about mutual funds that are more tax friendly. There are some actively managed funds that have the low turnover that you need.

If you are not sure whether or not there will be a capital gains distribution from your fund, you can login to the website of the company that manages your mutual fund every year in October to see. If you find that the distributions are going to be large, you will need to determine whether or not the fund is right for you. You can sell the fund to avoid the large distribution. Just make sure you don’t buy back the fund within 30 days of selling it or you will be playing against the IRS wash sales rules.

2. Unreliable past performance

The prospectus for a mutual fund may disclose that the fund’s past performance is not going to determine its future performance. This is partially true, as a great performer the year before is not always going to show good performance in the current year. There are even poor performing funds that step up their game and bring in good returns. However, there are some mutual funds that perform well for nearly a decade before seeing significant declines.

The way to look at past performance is this: it is very rare that a top performer is going to repeat that performance. However, if the fund is one that has not performed bad or great, it has a higher chance of performing better. It is best to diversify your portfolio so that you can offset this particular pitfall. If the fund performs well in consecutive years, then you come out further ahead.

3. There are going to be fees

Mutual funds can be considered expensive because there are a lot of fees. There may be sales fees, 12b-1 fees (marketing, service, and distribution costs), management fees, and a number of others. It is important to do research on each mutual fund to see how much it will cost. You need to evaluate if there are front- or back-end sales loads, if there is a high expense ratio, or if there is a 12b-1 fee. This is when you ask yourself if you would be getting what you pay for, especially if there is a similar fund with a lower expense ratio and fewer fees. This is information that can be found in the fund’s prospectus, as well as the websites for the funds that you’re interested in.

If the fund has an upfront load, then that is how much it is going to cost for the purchase of the shares. For example, you may have to pay a 2% charge. This means 2% of the money you invest is going to be taken right off the top with the remainder being invested. If the fund has a back-end load, this can be considered a redemption fee because the fee is charged when the shares are sold. This amount is taken out of the amount of money the shares are sold for.

4. Stock purchase limitations

Some of the stocks that are purchased may be considered sub-optimal. This is because mutual fund managers cannot sit on cash when it is given to them in order to wait on the best time to invest in a stock to place within the fund. The fund manager has to turn that money around by buying stocks that fits within the guidelines that are outlined on the prospectus. For instance, a large growth stock cannot be placed in a small value fund, even if the large growth stock would present a better buying opportunity. If there are no optimal buying options available, then the fund manager is forced to choose from what is.

5. The mutual fund is too diversified

A mutual fund is going to contain a number of stocks that fits within its guidelines. However, it is possible for it to become overly diversified, which can be dangerous. This makes it difficult for the fund manager to keep an eye on the high potential stocks that could really make a great deal of money. In fact, it can be almost impossible to keep track of these potential high performers. This forces the mutual fund to look a lot like an index fund in that its performance simply reflects an average. It is ideal to find out how many stocks are within the fund and the fund manager’s record managing that account to see how they are able to keep track.

If you watch out for these pitfalls, you will find that you can make a better decision as to what mutual fund you buy, how much risk you are willing to take, and even the reasons why you invest your money. You may find yourself achieving higher returns while paying lower fees.

Ginger has over a decade of experience in the area of personal finance. She has provided informative content and advice on a number of finance-related topics to individuals in the U.S. and Europe. She is able to do this because of her personal and professional experience, which includes work in the financial sector and 10 years in tax preparation. She resides in Ohio with her husband and three children. Ginger on Google+

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