What is a Mutual Fund?
Mutual funds rely on a professional investment expert to actively manage investments on behalf of others, at a set fee with a expectation that the active management can take advantages of market trends and/or informational discrepancies to “beat” the overall market.
Mr. Bogle, the founder of Vanguard, believed that it was more important to stay invested than to trade in and out of the market and created an ‘index fund’ that tracked the S&P 500 (Vanguard 500, VFINX). Index funds thus have a different strategy than the idea of beating the financial market as after fees most active managers can’t beat the financial markets. There are hundreds of index funds (where each tracks its own benchmark) and beauty is that they charge a small fraction of active management fees.
Picking the right mutual funds requires watching their fees, diversification of their holdings to mitigate risk and most importantly a long-term thinking.
A smart diversification strategy mixes stock funds (large cap, mid cap, and small cap including value and growth strategies) and bond funds as well as funds that invest in domestic and overseas markets, and alternate assets (commodities, real estate, …).
Another strategy investors should follow is “rebalancing” of their portfolio. Each year, you should take a look at mix of funds in your portfolio to make sure they still agree with your overall strategy of diversification. If e.g. large cap portion of your portfolio has done especially well compared to small cap and international funds, it will grow to become an outsized part of your portfolio. Each year, rebalancing your funds allows you to avoid overexposure to any particular portion of the market. Typically a rebalanced portfolio keeps your risk exposure to your target risk appetite.
Important To Note: Past performance is no guarantee of future performance of any financial security (stocks, mutual funds, and ETFs). Chasing performance is one of the fund investing errors you should always avoid. Diversification of your portfolio when rebalanced on an annual basis can help mitigate this problem.