Mutual funds are an easy way for beginning investors to put their money to work in the markets. But before you invest in mutual funds, it's important to know what to watch out for. With index funds that are passively managed and tend to have low expense ratios and actively managed funds that promise the potential to outperform but typically at a higher cost, you need to know what you're buying before you invest. Following these steps can give you a better sense of how to be smart with mutual fund investing.

Step 1: Decide whether you want to go active or passive

The biggest decision you'll need to make as a mutual fund investor is whether you think active management is worth the extra price you'll pay. Unfortunately, a large majority of actively managed mutual funds end up underperforming the major stock market benchmarks, making it counterproductive to spend more money to invest in them. However, a handful of fund managers have been able to demonstrate sustained outperformance over the long run. If you're confident that those track records are legitimate -- and that they'll continue -- then it can make sense to invest at least some of your money actively in order to try to capture the prowess of superior fund managers.

Mutual fund newspaper section with glasses.

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Step 2: Minimize fees

Regardless of which type of mutual fund you end up choosing, it always pays to economize on costs. First and foremost, make sure that you don't pay an up-front sales load on a mutual fund purchase, as doing so simply diverts a percentage of your initial investment into your broker's wallet. Equally important but often overlooked is the impact of high annual expenses. Paying more than 1% for an active fund makes it very difficult for a fund even to match the performance of its benchmark, let alone surpass it on a consistent basis. With index funds offering expense ratios of less than 0.1%, you don't have to pay a lot for mutual funds.

Step 3: Pick a diversified portfolio of funds

In buying mutual funds, it's important to look beyond the mere number of funds you own and make sure that those funds actually own different investments. If you have five mutual funds but they're all index-tracking funds that follow the S&P 500, then you actually have no more diversification than you'd have owning a single fund. Instead, look to buy mutual funds with different investments, such as stocks, bonds, real estate investments, and other alternatives. Within categories, look for other ways to diversify, such as with a foreign stock fund to go with a U.S. stock fund. That way, you'll have a balanced portfolio that can thrive under a wider range of market conditions.

Step 4: Find a family

With mutual funds, the cheapest way to set up accounts is directly with the fund company that offers shares. Therefore, if you can find a company that offers a family of funds that you like, then it makes things a lot easier, because you can make a single deposit that gets divided into different funds on a regular basis. That's not to say that you have to stick with one family, and many investors feel more comfortable diversifying by fund provider. However, those who do find certain fund families that give them the exposure they want find that their tracking is easier than it is with multiple fund families to deal with over time.

Step 5: Don't stop watching

Finally, even once you've selected and invested in a mutual fund, your job's not over. You also need to monitor your mutual funds to make sure that everything continues to run smoothly. If there's a change in investment management, you'll want to watch closely to see if the new manager continues to do things as well as the old manager did, especially for actively managed funds. With index funds, a change to a new benchmark index could signal a shift in the performance of the fund, and you'll have to decide whether that's consistent with your investment strategy going forward. Most importantly, a rise in fees can signal a change in fund philosophy that you won't like.

Mutual funds are a great way to invest without a huge amount of effort. By following these steps with your mutual fund investments, you can make sure that you'll get the most out of your funds as you can.

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