After you've selected one or two fund families that you feel comfortable with, you should be ready to start looking for a particular fund where you can invest your money. But before you invest in any mutual fund, by law the fund company must give you a copy of the fund's prospectus.
The prospectus is a legal document which outlines the objectives of the fund, and it explains the risks and expenses associated with the fund. The fund also may provide other marketing information like colorful pamphlets, but the prospectus is the defining document. Most of the important information is in the front of the document.
As you read the prospectus, understand the assets that the fund will invest in, and some of the associated risks. Make sure the fund's objectives meet your objectives. Don't buy a fund just because it's been hot recently.
Remember that no mutual fund guarantees that you will get your original investment back. This also applies to mutual funds that are sold through banks. Funds sold through banks do not carry FDIC insurance.
The prospectus shows expenses broken into two groups. One is for transaction fees like a load when you buy into or exit a fund. The other is the ongoing fund management fees.
There also should be a table which shows you how much you might pay in total expenses over a three, five, or 10 year period of owning the fund. If the fund tries to confuse you with a lot of loads or other fees, this table gives you a better idea of how much the fund may cost you in dollars and cents.
In addition to reading the prospectus, you should request and read the latest annual and semi-annual report for the fund.
I consider these reports to be important, but for some reason the government doesn't require a fund to send these reports to you before you invest. But if you ask for the reports, the fund company will give them to you.
These reports show which securities the fund actually invests in. If you want to invest in blue chip stocks but the annual report discloses that the fund's largest holdings were Federated Fido and Rover Incorporated, you might want to look elsewhere.
Look at the list of securities that the fund owns. If a lot of familiar companies pop up, the fund might be a good investment for you. If you hardly know any of the firms listed, you may be better off in another fund.
Either the prospectus or the annual report also should contain performance information about the fund. You should look for a table or graph that shows the fund's performance for the last five years, and even ten years if available. You should think twice before investing in a fund that hasn't been around for at least five years.
You should compare the fund's performance with a suitable benchmark index. Stock funds could be compared with the Standard & Poor's 500 index, for example, but make sure you're comparing apples with apples.
You especially should note the fluctuations in the fund's value. Does the fund's value change so much that you'd be scared out at a low point? The past doesn't predict the future, but you should still understand how the fund might react in the future.
Also note the distributions made by the fund. Even if the fund's share price doesn't appreciate noticeably, does the fund distribute a lot of internally realized capital gains or interest payments? Also consider the tax implications of these distributions if you're investing outside of a retirement account.
In addition to the fund's prospectus and annual reports, you probably should see what third party information services have to say about the fund. Two of the leading information services are Morningstar and Value Line.
Services like Morningstar provide a wealth of information about funds in a very condensed format. Much of information is simply a duplication of what you'll find in the annual report or prospectus, but Morningstar provides independent analysis and historical information about the fund.
Morningstar reports can be found at many public libraries and also on America Online. The reports are great references, but don't get carried away with some of the "star" ratings.
If you're looking at two roughly equivalent funds and one has five stars and the other only four stars, I'd probably go with the fund that has the lower expenses and forget about the star rating. Past performance isn't a good predictor of future performance, but funds that have low expenses rarely raise their fees and this could make the difference in the future.