First, let’s back up for a moment.
What Exactly Are Mutual Funds, And Why Do I Care?
A fund manager deals with all the buying and selling, which makes things easier on you and helps even out the risk in your portfolio. So, basically, mutual funds are like baskets full of different investments—when you own part of a mutual fund, you own a sliver of each of those investments, too. They’re a great way to dive into investing, since you don’t have to pick and choose your own stocks (which we counsel against, anyway).
Many companies that offer 401(k)s let you choose between a few mutual funds. Before you decide which one is best for you, make sure not to fall into one of the big 3 mutual fund traps.
1. High Operating Fees.
An “expense ratio” is the fee that a mutual fund charges for its operating expenses. All funds have an expense ratio, but yours should be as low as possible. Here’s why:
Imagine that one fund has a ratio of 3% while another’s is 0.05%. If you invested $5,000 and held it in each fund for forty years until retirement—and each fund returned a profit of 8% each year—investing in the first fund would cost you over $18,000 in fees and more than $58,000 in foregone earnings. But, investing in the second fund would cost you under $700 in fees and less than $1,500 in foregone earnings. You’d lose out on more than $56,000 simply by investing in the fund with the higher expense ratio! To play with the numbers, check out this mutual fund calculator from the Securities Exchange Commission.
Usually, index funds (which try to match the returns of an index like the S&P 500) have the lower fees than actively-managed mutual funds (which try to beat an index like the S&P 500). Even if actively-managed funds have slightly higher returns, index funds often come out better over time because high fees cut into profits.
KEY TAKEAWAY: Choose a mutual fund with the lowest possible expense ratio.
2. Unnecessary Commissions.
A “load fee” is jargon for an extra commission you have to pay. Our opinion? Loads suck. While they sometimes make sense for institutional investors, we don’t think you should be investing in a mutual fund that has any load at all.
KEY TAKEAWAY: There are lots of really great no-load funds out there, so go for mutual funds that don’t charge load fees.
3. Funds That Trade Like Crazy.
The frequency at which a fund buys and sells investments is called its “turnover rate.” Taxes favor investors who hang on to investments for longer periods of time, so a lower turnover rate is generally better. Funds that trade a ton have to pay for all those trades, plus they incur higher taxes. Index funds again come out ahead, as they generally have to trade only occasionally to remain in sync with an index.
KEY TAKEAWAY: Look for a fund with a low turnover rate.
Don’t be intimidated by the investment vocabulary. Just try to find the mutual fund with the best consistent returns, and watch out for the words expense ratio, load fee, and turnover rate.