Picking individual stocks can be intimidating to new investors. Investing in mutual funds, however, eases some of the pressure of building a stock portfolio.

“Mutual funds are good choices for first-time investors,” says Jeremy Torgerson, CEO of Denver-based nVest Advisors. “You’re diversified across dozens or even hundreds of investments from your very first dollar in a fund that’s been professionally selected to fit the specific objectives of the fund’s investors.”

That, Torgerson says, takes much of the guesswork out of answering a question novice investors often have – does this stock give me what I want? Although mutual funds are an all-in-one investing package, newbies can still choose the wrong ones thanks to some common mistakes.

Chasing performance

In fairness, all investors, not just newbies, can fall into this trap. “It’s easy to pick on first-time mutual fund buyers, but the inconvenient truth is that most investors pay far too much attention to performance,” says Daniel Kern, chief investment officer of TFC Financial Management in Boston.

That can be more damaging when short-term returns skew the picture. Many of today’s top-performing funds end up being tomorrow’s bottom performers, particularly when measured over a one- or three-year period, Kern says.

While important, performance shouldn’t be the sole reason for choosing a fund. Katharine Perry, associate financial consultant at Fort Pitt Capital Group in Pittsburgh, says investors should look at the company’s overall track record and management team. The fund manager’s credibility and management style should also factor in, as should the fund’s strategy.

“A fund may be doing well now because a sector is up, but that doesn’t necessarily mean it’s going to continue to do well if it has an unfavorable strategy in the long term,” she says.

Instead of being wowed by a fund’s recent performance, aim for sustainability. When you have decades to invest, a fund that generates steady, consistent returns over time may prove much more valuable than one with returns that are a series of peaks and valleys.

Making only surface comparisons

A mutual fund is a collection of stocks, bonds, and other investments, with no two funds exactly alike. To determine if a fund fits your risk tolerance and objectives, look at the underlying investments.

Subtle differences between funds can affect your investments significantly. Kern uses the Russell 2000 index, which includes many unprofitable companies, as an example. “In certain environments, the Russell 2000 will outperform the Standard & Poor’s 600 index, which has a more selective approach.” Both indexes follow small-cap companies.

Exposure to a specific market isn’t the same thing as a fund’s investment strategy, Torgerson says. For instance, if you’re an aggressive risk taker who panics when your account value drops 20 percent, look for a balanced strategy of stocks and bonds, Torgerson says. Broad exposure to the market could take more than one fund to accomplish unless you’re using an allocation fund, which invests in stocks, bonds, and cash.

Target-date funds are one option for first-time, set-it-and-forget-it mutual fund investors. The fund’s asset allocation and corresponding risk exposure adjust automatically over time as retirement nears. You still, however, need to review the underlying investments and the fund’s glide path – the trajectory at which the asset allocation adjusts – to make sure you’re not taking too much, or too little, risk.

When investing in multiple funds, checking for any overlapping holdings. “If funds have a big weighting in the same companies, you may be incurring more risk through overexposure,” Perry says. Also, you should understand that index funds are an unmanaged basket of both good and bad companies. You may get power stocks that drive index performance along with companies that aren’t doing as well.

Overlooking cost

Managing investment fees is something you want to get right from the start. The more you pay in fees, the more you may shrink your investment returns.

There are two basic fees to understand: the expense ratio, which covers transaction and management costs, and the sales load, which is a commission paid when you buy or sell shares. Lonny Powell, founder, and president of Alliance Retirement Solutions in Louisville, Kentucky, says to evaluate a fund’s fees in the context of its annual returns.

Assume you have two mutual funds, one with a 9 percent annual rate of return and an expense ratio of 1.7 percent, and another with an 8.5 percent annual return and an expense ratio of 0.5 percent. The actual return for the funds, less the expense ratio, would be 7.3 percent and 8 percent, respectively. “Although the second fund has a lower annual rate of return, the lower fees make it the higher return option,” Powell says.

Sales loads are determined by the class of shares you buy. As a new investor, avoid funds that charge a load and stick with low-cost options, such as exchange-traded funds or index funds, whenever possible. If you’re working with an advisor, “fees aren’t necessarily a bad thing, but know what you’re paying for in terms of performance and service,” Perry says.

A fund’s turnover ratio can help you understand how actively the manager trades securities within the fund, says Thomas Walsh, client service and portfolio manager with Palisades Hudson Financial Group in Atlanta. Funds with high turnover imply more frequent trading, which usually means higher trading costs.

Besides fees, you should also consider what a fund may cost you in taxes. A higher turnover rate, for example, may trigger more taxable events. Walsh recommends placing certain types of mutual funds in an investment account based on its tax status. High-income or high-growth funds may be better suited to tax-deferred accounts, like a 401(k) or individual retirement account. Funds that are more tax-efficient may be more appropriate in a taxable brokerage account. “Strategic placement of mutual funds in different account types is known as asset location, and it should be part of your overall investment strategy,” Walsh says.

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