What Type of Return Do You Look for in a Mutual Fund?

When investing in a mutual fund, there are tens of thousands of funds to choose from, making it difficult to decide where to put your money. Usually, an investor has a goal in mind and tries to achieve a specific return from the investment for a given amount of risk. So what type of return do you look for in a mutual fund?

Different funds are designed to achieve different amounts of return. Some funds attempt to mimic a particular market index, such as the S&P 500; others try hard to beat indexes by placing bets on particular business sectors of the economy. Some funds don't try to beat the market, rather provide a steady consistent return that an investor can count on year after year.

So ultimately, the return an investor looks for depends on his or her investment goals, age, current and future income, assets, and savings, and their desire for capital appreciation or income.

The first thing to remember about a mutual fund is that past performance is not an indicator of future performance. While past performance does not predict future returns, it can, however, show how volatile or stable a fund has been over a period of time. In general, the more volatile a fund, the higher the risk, and the potential for higher returns. The less volatile the fund, the lower the risk, and the lower the returns.

Read the fund's prospectus and shareholder reports to learn about its investment strategy. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals.

All funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. For example, the fund's investments could be very sensitive to interest rate changes. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you. Then, based on these criteria, you can get a reasonable idea of what type of returns to expect.

Investors should match the term of the investment to the time period they expect to keep the investment. Money that may be needed in the short term (for example, for car repairs) should generally be in a less volatile, less risky fund, such as a money market fund. Money not needed until a retirement long into the future can be invested in longer-term, higher-risk investments, such as stock or bond funds. Investing short-term money in volatile investments puts the investor at risk of having to sell when the market is low, thereby incurring a loss. Investing over the long term in very stable investments, on the other hand, significantly reduces potential returns.

Diversifying, by investing in a number of different types of funds, can reduce risk and help overall performance. If all of an investor's mutual funds belong to the similar types of funds or asset classes, the total amount of money invested might not be as diversified as it may seem. Funds may overlap and move down or up together resulting in similar returns. Holding too many different funds, however, produces the same effect as holding an index fund but with higher expenses.

When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them. And, in addition to owing taxes on any personal capital gains when you sell your shares, you may also have to pay taxes each year on the fund's capital gains. That's because the law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that can't be offset by a loss. These taxes also hurt performance. Funds with lower taxes, or the possibility of taxes, can help a portfolio's performance.

A few good places to research mutual fund types and their performance:

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