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Depending on your particular situation and goals, you might benefit by including mutual funds in your portfolio. The first step when constructing any portfolio is to define your objectives . Most investors use mutual funds in their portfolio in order to achieve diversification but mutual funds can be used for a number of other purposes as well . This section will examine all of the central issues involved when adding mutual funds to a portfolio: the risks, the diversification benefits, and the tax consequences. It will also give you some advice on how to select and purchase mutual funds, and how to maintain your portfolio after it is established.

Diversification and Other Benefits

Mutual funds are generally lower-risk investments, especially when compared to individual stocks. This is because mutual funds are by definition diversified investments. When you purchase a share in a mutual fund, you are actually purchasing a very small amount of ownership in the many securities that the fund holds. So, if one of the securities in the fund happens to perform poorly, there is always the chance that other securities in the fund's holdings will be able to offset any losses. The opposite, of course, is true as well: when you hold a single security that realizes a large gain, you receive all of the gain, but when you hold a mutual fund, any large gains in one security might be offset by losses in another. Most investors use mutual funds in order to diversify their holdings and provide some stability to their portfolios.

You can also use mutual funds in your portfolio to target a specific asset class in which you want to invest without purchasing individual securities in that class yourself. For example, you might know that you want to invest in bonds because you are looking for fixed income, but you might not know which specific bonds to invest in. Even though bonds are considered low-risk investments, selecting the right individual bonds yourself might be difficult, so instead you could just invest in a bond mutual fund and have the mutual fund manager make the decisions about which bonds to buy for you.

Choosing a Mutual Fund

Once you've identified your reasons for including mutual funds in your portfolio, the next step is to select the fund or funds that will give you the best performance. Remember, however, that the mutual funds you pick must fit your overall strategy and make sense with the rest of your portfolio. First, you should decide what types of funds you want, and then choose ones in those areas; or if you've already selected (or already own) some good funds, fill in the gaps. You can use a screen to put together a list of candidates (or skip this if you already know which ones you're interested in), and then research them by getting the fund's prospectus . Most of the information below is provided in the first few pages of the fund's prospectus. You can also find more information from the mutual fund company's website or from its annual report .

Performance

Investigate performance, both before and after taxes . Look at the fund's historical performance over a long period of time (3, 5, and 10 years). Why? Because there's a positive correlation between past and future results (although the correlation is far from exact, as some funds do very well one year and very poorly the next). It's dangerous to focus only on recent performance: it could be a fluke, or the manager could be good only in bull markets. Keep the following questions in mind when investigating the performance of a particular mutual fund:

• Is the performance consistent?
• How is the performance when compared with peers and indices? If you expect that a fund you're considering won't keep up with the indices, you should just get an index fund instead .
• How is the performance after taxes and costs (front and back-end loads and expenses) are factored in? This is what will end up in your pocket.

Also investigate the mutual fund's investment style. Consider the following:

• Growth or Income? Large cap or small? U.S. or international?
• Does the fund's investment style match your goals? Has the style been consistent through time?
• What level of risk do they take on? Are you comfortable with this? Does the performance reflect this level of risk? (if the fund takes above average risk, performance should be above average)
• The strategies that they use: short selling, leverage, derivatives, market timing .

Look beyond the name of the fund to determine the style; names aren't always indicative of the true style. For example, a fund that started out as a small cap may have ballooned in assets to the point where it's forced to buy larger cap stocks, but the name of the fund wouldn't have changed. Specific holdings might give some clues as to investment style. Keep in mind that mutual funds are only required to divulge their holdings twice a year, and few do it more frequently, so by the time you find out what they have, their holdings have probably changed. Also, many funds 'window dress' their portfolios with yesterday's winners to make the reports look good, so these semi-annual reports aren't a perfect indicator of investment style.

Manager

This is important because the manager makes most of the buy and sell decisions. If the manager has been leading the fund for a long time, you can be confident that the fund's investment style and strategy (discussed above) are the manager's. If not, determine the manager's style based on previous funds that have been managed by him/her. Take a look at what the manager says in the annual report and the prospectus. Find out if the manager has substantial personal assets invested in the fund. If not, find out why.

Fund Family

Different fund families have different policies, areas of expertise, and services. You should check out several of them to find out their particular policies and services.

Services

You can get this information directly from the fund. Call them or look in the prospectus.

• Account information and availability
• Newsletters
• Annual reports
• Checking accounts
• Phone redemption and switching
• Phone account info and quotes (24 hrs?)
• Web account info and quotes (24 hrs?)
• Hours of live representative
• Wrap accounts
• Margin loans
• Other Considerations
• Loads and other fees
• Minimum investment

Here are a few additional tips to consider when choosing mutual funds for your portfolio:

• You don't need to own a lot of different mutual funds. A handful should be enough to achieve diversification, because each of them in turn invests in dozens of stocks, bonds, etc.
• Consider dollar cost averaging, the practice of investing the same amount each month . This is an easy way to ignore the market fluctuations and focus on the long-term picture

The above advice should get you started on the right path. You will probably discover other things to consider as you investigate further. To gather more information, check out mutual fund magazines, talk to others about their strategies, and check out some fund ratings.

Buying and Redeeming Shares

Depending on the mutual fund you decide to purchase, you might be able to buy shares directly from the fund. This would allow you to sidestep any brokerage commissions. For some mutual funds, however, you may need to go through a broker; check with the fund to find out which methods they allow. A third alternative is to go through a mutual fund supermarket where you can easily move your money between funds with a single account . Be aware that not all mutual funds participate in supermarkets, although hundreds do.

There will probably also come a time when you want to sell, or redeem, your shares. For example, if you find that your fund is not meeting your expectations or if your particular set of investing objectives happens to change, then you might decide to sell shares in one or more of your mutual funds and look into other funds or other investments entirely. Check out your fund's prospectus in order to find out the details of their redemption process. Most funds allow you to redeem by telephone, but some might require that you send in a form.

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