HOW FUNDS WORK Popular in England more than 100 years ago, the first mutual funds began operating in the United States in the 1920s. A fund essentially represents a pool of investors who combine their money and collectively hire professional management to make investment decisions. Legally, it is a corporation, or trust, whose sole purpose is the investment of its shareholders' assets. Investments are spread over a variety of securities (equity, fixed-income, or a combination of the two) and are managed in pursuit of specific, predetermined investment objectives. Unlike a stock, which has a fixed number of shares, most mutual funds stand ready to issue and redeem shares continuously. This feature gives the fund "open end" status. Thus, individuals can make investments and withdrawals easily.

Mutual funds are very tightly regulated by the U.S. government. These regulations provide more investor safeguards than for any other type of investment. As a result, the mutual fund industry has built a solid reputation that has helped to fuel its phenomenal growth—to over $1.5 trillion in assets today.

Currently, there are approximately 5,000 mutual funds that are publicly offered in the United States. Funds that invest in taxable and tax-free bonds account for about 60% of total mutual fund assets. Equity-oriented funds command the remaining 40%.

SPECIAL SERVICES Most mutual funds offer a wide variety of shareholder services that facilitate purchasing and redeeming shares and tracking investments. Several of these services are predicated on linking the investor's bank account with a fund account. Automatic Investing is one such service; it enables an investor to make single or periodic purchases of fund shares using preauthorized bank drafts drawn against his or her personal checking or savings account. Another such service is Telephone Redemption, through which an investor can liquidate shares by phone and have the proceeds mailed in the form of a check or deposited automatically in his or her bank account.

A third popular service is Automatic Dividend Reinvestment. Under this program, investors purchase additional shares whenever income and capital gains distributions are paid by the fund. With such reinvestment the initial mutual fund investment compounds over time.

Retirement Plans, including IRAs, Keoghs, and 401(k)s, are offered by most major mutual fund companies as another popular service. As a redemption or retirement program, an investor can initiate a Systematic Withdrawal Plan to redeem a number of shares or withdraw a specified sum of money each month or quarter to provide steady income.

FACTORS INFLUENCING FUND PERFORMANCE Understanding the forces that drive the performance of mutual funds is a prerequisite to investing wisely in them. For equity funds, the performance of the stock market is paramount. The price of stocks, of course, is influenced as much by investors' perceptions as by such quantifiable factors as earnings and dividend growth or the vagaries of the economy.

Within subsets of the equity universe, factors influencing performance vary widely. For specialty or so-called sector funds, the performance and economic fundamentals underlying the particular sector(s) in which the fund invests are critical. For international funds, currency exchange rates can have a profound effect on a portfolio's performance: A rising dollar will depress the value of a fund's foreign investments in U.S.-dollar terms, while a falling dollar can result in a windfall to an international fund investor. Some international funds employ hedging strategies to reduce currency risk.

Bond-fund investors must be aware of two major factors that drive the performance of bonds: interest rates and credit quality. As interest rates rise, bond prices fall, and vice versa. The share prices of bond funds holding longer-maturity issues tend to rise and fall more sharply as interest rates change, while those with shorter maturities tend to be less volatile. Similarly, bond funds holding issues of higher credit quality tend to be less sensitive to changes in the economy than those holding lower-quality bonds.

DEVELOPING A FINANCIAL PLAN The purpose of financial planning is to build and preserve wealth. Investing is only one part of an overall financial plan. Other aspects include insurance coverage, tax planning, retirement planning, and estate planning. Investing encompasses all means by which one accumulates assets, and in investment planning one must consider all asset categories: a home or other real estate, tangibles such as collectibles or gold and jewelry, the cash value of any insurance policies, social security benefits and the value of other retirement plans, savings accounts, and traditional financial investments such as stocks, bonds, and mutual funds. Factors that will affect an investment program include one's family situation, age, tax status, income requirements, and specific financial goals.

In the sections that follow, we will provide a framework for individuals to begin building an overall financial strategy and investment plan, focusing on mutual funds that are appropriate for implementing such a plan.

IDENTIFYING GOALS Before an investor can consider long-term financial goals, it is essential that he or she establish minimal protection against financial emergency. Most financial planners recommend keeping an adequate cash reserve in highly safe, liquid investments, such as a savings account or money market fund. (Although most investments can be converted to cash, doing so on short notice could result in losses.) The amount of money to set aside varies according to individual circumstances; a rule of thumb is six months' living expenses.

Once adequate reserves are established, an investor needs to consider and plan for specific goals. For a young couple these may include marriage, children, or purchasing a home. Couples with children may wish to prepare for college expenses. Older couples or individuals will want to prepare for retirement. In realizing any of these goals, mutual fund accumulation plans are especially helpful, since they encourage regular, disciplined saving. Though individuals' situations and life experiences vary, most investors' lifetimes can be divided into four broad phases: early years, family years, pre-retirement, and retirement. Below we provide general descriptions of each stage. We recommend that each investor consider how his or her situation relates to these and begin to formulate financial goals in as broad a context as possible.

The early years encompass the period from when an individual starts his or her first job until marriage and family responsibilities and expenses begin to dominate. Many young people fail to recognize the importance of saving during this period because there are so many short-term pleasures to be pursued and desires to be satisfied. Worthy goals during this period might include saving to purchase a car or home or to start a family. Young people often incur low living expenses and, in the case of many couples, benefit from two incomes. Most have no major responsibilities. These circumstances are ideal for beginning a serious, long-term investment program. Perhaps most important is the very long time horizon of young investors, so that even small, regular investments have an excellent opportunity to grow significantly. Young individuals and couples also can afford to assume above-average risk, since they have ample time to recoup any temporary losses.

During the years in which one's family is growing, other financial concerns often take precedence over regular saving and investing. Supporting a comfortable lifestyle for a spouse and children, protecting the family should an income earner die or become disabled, and preparing for the children's college costs are important during this period. Because time still is on the side of the investor during these high-expense years, it is important to continue to save and invest regularly, even in small amounts. Building retirement assets through an IRA or pension plan is also very important at this time. As long as adequate cash reserves are maintained, investors can afford to take above-average risks during these years—particularly with retirement-plan assets—in pursuit of long-term growth.

The pre-retirement period is critically important for consolidating retirement goals. For many "empty nesters" the mortgage is paid, and family income is at a peak. Now is a good time to accumulate additional financial resources for retirement. As retirement nears, however, there is less time to make up for investment losses. Accordingly, individuals in this phase need to gradually reduce their risk exposure.

To a large degree, foresight and diligence during the first three phases of one's investment "life" lead to financial independence in retirement—the final phase. During retirement, the overriding concern is income, since the payouts from a pension plan and social security are substantially less, in most instances, than the income earned from employment. Conservative, income-producing investments are highly appropriate at this stage since losses can directly impact one's standard of living, and there is little time to recoup any losses. For those who are wealthy beyond what they require to maintain a comfortable standard of living, estate planning is an important consideration. Trusts can protect the value of an estate from taxes while preserving the individual's control over investment decisions.

The Value Line Mutual Fund Survey can be a vital tool in developing and maintaining a portfolio of mutual funds. Once investors have determined their financial goals, it is time to focus on identifying the kinds of funds that will help to realize those goals. This selection process begins by evaluating risk and by understanding how to control it.

EVALUATING RISK Value Line recognizes that the evaluation of any investment begins with an assessment of risk. Investors must consider their tolerance for risk and weigh it against the desire to achieve a specific financial goal. Identifying risk, which can be defined as the uncertainty of achieving a desired return, is difficult. An investor seeking a higher return must be willing to tolerate a higher level of risk in order to have a chance of achieving that desired return. By contrast, someone willing to accept a lower rate of return has a higher probability of achieving his or her objective. A key aspect to evaluating risk is the investor's time horizon. Investors with long horizons can afford to assume a higher level of risk, since there is a greater chance that, over time, the investment will pay off. Investors with shorter horizons should choose lower- risk investments, since they may not be able to wait out a period of weak investment performance.

There are two types of risk: market risk and unique risk. Market risk is the degree to which a security's behavior is related to the overall behavior of the market. If a stock fund behaves in a fashion similar to the overall stock market, it is said to have a high degree of market risk. If the market declines, there is a strong likelihood that the fund's value will decline as well. Unique risk pertains only to a particular security. It is independent of changes in the stock market. For a bond, credit risk is unique risk, since a bond's credit rating is solely a function of the issuer's financial condition. In assessing the level of risk that is acceptable, investors must consider their investment portfolio in its entirety and understand that the risk of certain types of investments can be reduced, even significantly, through diversification.

CONTROLLING RISK THROUGH OPTIMIZATION Asset allocation, at its simplest, means diversification of financial investments among stocks, bonds, and cash. At a more sophisticated level, asset allocation involves trying to squeeze the greatest potential return out of a given level of risk. Given a choice between assets, an investor stands to realize the greatest return by choosing, to the exclusion of all others, the asset expected to perform best. Diversification automatically dilutes the potential return. But because some assets typically rise when others fall, it is possible to diversify among asset classes in such a way as to lower the potential risk by a greater amount than one has lowered the potential return. This concept of portfolio optimization captures the essence of what all investors are trying to accomplish: getting the highest potential return within the limits of acceptable risk.

DETERMINING THE PORTFOLIO MIX Differences of opinion abound concerning how to determine the percentage of assets that should be invested in stocks, bonds, and cash, respectively. Perhaps the simplest rule of thumb is this: The percentage of assets in bonds and cash combined should equal the investor's age. The remainder should be in common stocks. This oversimplification is intended only to illustrate the conventional wisdom: A young investor seeks growth, primarily through stocks, while an older investor requires stability and the income generated by a larger percentage of assets in bonds and cash. Clearly, individual preferences and circumstances must be the determining factors in making asset allocation decisions.

CHOOSING INDIVIDUAL FUNDS For some people, selecting individual funds is the most difficult aspect of mutual fund investing. But for those who approach investing in a diligent and thorough manner—first evaluating their circumstances and goals, then assessing risk tolerance, and finally determining desirable portfolio allocations—the final step of selecting funds is far less difficult. The reason is simple: Investors too impatient to make an adequate assessment of their overall financial position will unwittingly try to make up for this deficiency in their fund selections. If they can simply find the "perfect" fund, then they assume that other considerations won't matter. The problem, of course, is that the definition of a perfect fund is subjective; it depends on the goals and profile of each individual. Therefore, investors who have a clear picture of their goals will always find it far easier to identify appropriate funds.

We recommend that once investors have identified appropriate fund categories, they begin by using the Value Line Mutual Fund Ranking System to narrow the field. Since investment always begins with risk, investors should first look at funds whose Risk ranks meet their criteria, then focus on those with the highest Overall rank. At that point more detailed research is required to make the final selections. We suggest taking into consideration a combination of factors, including a fund's long-term track record, consistency of management, and the reputation and the organization of the fund family. Although different traits are desirable in different situations, most investors will do well to emphasize consistency of returns as the framework of highly ranked funds.

DOLLAR-COST AVERAGING Once funds have been selected, a disciplined, regular investment program is an ideal way to build wealth. Dollar-cost averaging, one of the most widely used systematic investment programs, involves investing a fixed sum of money at regular intervals, regardless of how the market is performing. With dollar-cost averaging an investor will purchase more shares at lower prices and fewer shares at higher prices. The result is a lower average cost per share.

LOAD FEES AND EXPENSES Mutual fund shares are sold in two ways: directly or through a sales force. Those sold directly usually carry no sales charge and are known as "no-load" funds. Those sold through a sales force usually charge a commission or load. Load funds can be further subdivided into two groups: those charging a front-end load and those charging a back-end load.

A "front-end" load results in a deduction from the initial investment. By law, no fund may charge a front-end load of more than 8.5%. Such loads average 5% for stock funds and about 4% for bond funds. A back-end load (also known as a contingent deferred sales charge) applies if shares are redeemed within a certain period of time, usually five years. Such charges decline over time. For example, a back-end load may start at 5% during the first year and decline by one percentage point each year, so that the charge is eliminated after five years. Back-end loads often are accompanied by 12b-1 fees.

Named for the SEC Rule that authorizes them, 12b-1 fees are charged yearly, ostensibly to help promote the fund, thereby increasing its assets and lowering expenses. In reality, the fee has become part of the overall sales-charge structure of many load funds.

Mutual fund sales charges are regulated and cannot exceed specified amounts. These rules vary depending on certain fund circumstances, but in no case (as indicated above) may a front-end load exceed 8.5%. The ceiling on 12b-1 fees is 0.75%, with an additional 0.25% service fee permitted for funds offering certain shareholder services. Excluding funds that charge only a front-end load, mutual fund sales charges may not exceed 7.25% over the life of an investment.

FUNDS OFFERING MULTIPLE SHARE CLASSES In order to accommodate the greatest number of potential investors, many funds offer separate classes of shares, each carrying different load structures. The most common convention is to classify shares offered with a front-end load as "Class A shares," and shares with a back-end load as "Class B shares."

In some cases, shares purchased with a back-end load "convert" to the share class corresponding to purchases made with a front-end load after a certain period of time (generally six to eight years after purchase). The benefit of this "conversion" feature is that once the back-end shares convert, the 12b-1 fee is reduced or even eliminated.

A fund's performance figures and NAVs will be different for different share classes. The Value Line Mutual Fund Survey generally provides data for the oldest share class; or, if the share classes began at the same time, the class with the greater net assets is shown.

CHOOSING THE RIGHT CLASS OF SHARES If a load fund offers more than one share class, which one should an investor choose? The answer depends on a number of factors, including the specific sales, redemption, and 12b-1 charges, the redemption fee schedule for the back-end load shares, and whether (and, if so, when) back-end shares convert to front-end shares. Although it may be tempting to believe that the back-end load arrangement is always preferable (since there will be no sales charge if the shares are held to the conversion date), in reality the back-end shares are often more expensive in the long run, since the ongoing 12b-1 fees are so much higher.

By law, a fund's prospectus must provide a hypothetical example of the expenses incurred for each share class over a period of time. By comparing the relative expenses and fees and taking into consideration how long the investor plans to hold the shares, he or she can determine the appropriate share class to purchase.

LOAD VS. NO-LOAD: PERFORMANCE AND SERVICES The question of differences in performance of load and no-load funds has been studied and argued over decades. Most analyses have shown little or no difference in performance, while some recent studies have indicated a slight advantage for load funds. It is argued that this advantage is a result of better research and management at load groups. More likely, however, it is because load fund families tend to have larger individual funds because of extensive sales efforts and, therefore, lower average expenses. The argument is of little consequence, in any event, since any advantage enjoyed by load funds is usually eliminated once sales charges are deducted.

The important question is not whether load funds outperform no-load funds but rather what a sales load buys an investor. The answer in most cases is that a load pays for advice from a financial planner or broker on such matters as which funds to own, when to buy, when to sell, and how to plan for taxes. An investor should evaluate his or her need for such services before deciding whether to invest in load or no-load funds.

IMPACT OF EXPENSES Mutual fund expenses are measured as a ratio of operating expenses to average net assets. Such expenses include a fund's administrative and management costs but exclude portfolio transaction costs. Annual expenses typically range between 1.0% and 1.5% for stock funds and from 0.5% to 1.0% percent for bond funds. However, these expenses can range from zero (with management absorbing them) to 5% or more for very small funds.

Expenses always impact a fund's performance, since they are deducted from share values. For equity funds, the impact is generally less significant, since investment decisions are usually the major determinant of performance, and there is sufficient opportunity for profitable investment decisions to dwarf the effect of expenses. But for bond funds, whose returns fall within a narrower range, expenses can make a substantial difference. Bond fund expenses are of particular concern to investors seeking income, since the expenses are taken first from income and thereby reduce a fund's yield.

WHEN TO SELL A FUND Several factors make selling a fund appropriate. A change in management may be a reason to sell. In situations where management has changed it is important, however, to assess the likelihood that the fund will continue in the same manner as in the past. Such an evaluation begins with determining whether the fund was managed by a group or by an individual, how much autonomy management is given, and the degree to which investment decisions are prescribed by the fund's prospectus or other internal charters, systems, or methods. In some respects fund management systems can be compared to those adopted in preparing meals at restaurants. At one eatery, a star chef cooks up specialties each night according to his or her whims, while at another, series of recipes are rigorously followed night after night. Clearly, at the former a change in chefs is a major event (whether good or bad), while at the latter it doesn't matter much who is cooking from night to night—as long as the chef follows the recipes carefully.

If a fund's performance deteriorates over several quarters, investors should consider selling in favor of another fund that shows better results. If this appears to be the case, it is of critical importance to make a fair and accurate assessment of what constitutes poor performance. Investors who buy a fund because of the way it claims to invest should first consider whether or not the fund is doing what it said it was going to do. If the fund is following its charter, the investor must approach the sell decision from a different angle, questioning instead the viability of the investment concept itself.

It is not always poor performance that should prompt an astute investor to sell a fund. Investors who purchase a fund for a specific purpose should always sell when the fund is no longer satisfying that aim. To illustrate, consider funds that specialize in small-capitalization equities. Virtually all small-cap funds were laggards during the mid-1980s. A less sophisticated investor in a weak small-company fund might have sold in favor of a better performer. By contrast, a more sophisticated investor might have taken exactly the opposite tack, selling his stronger performing small-company fund, knowing that its strength resulted from its failure to maintain its small-cap style.

Investors should always sell a fund when their own goals have changed. This is easy to overlook, especially if a fund is performing well.

FOUR COMMON MISTAKES

1. Buying last year's top performer. At any given time there are funds that have posted phenomenal results. Unfortunately for the legions of investors who chase them, the same aggressive or specialty techniques that rocketed the fund to the top one year can lead to dizzying declines the next. As was the case for the slow-but-steady tortoise that beat the hare, a fund that performs consistently and lands in the top half of its group year in and year out will undoubtedly rise to the top 10% of all funds over a decade or longer. Again, the investor should purchase funds solely on the basis of how they contribute to his or her long-term financial goals.

2. Acting on hunches. Unless you have an uncanny knack for calling market trends, you are better off developing a consistent, disciplined approach and sticking to it. The most enduring trait of a successful money manager is discipline and consistency.

3. Selling too soon. Many investors fail to understand the style with which their fund is managed. When that style goes out of favor for several years, performance will suffer, but it will also rebound when the style returns to favor. Many investors wind up selling a fund right before its performance improves, in favor of a fund whose relative performance is about to turn weak. One should sell, of course, if the fund is doing badly because it is not sticking to any discernible style.

4. Owning too many stock funds. A diversified portfolio of stock funds is a good idea. But investors who own dozens of stock funds run the risk of overdiversifying. Investors who want a portfolio that behaves like the market should save themselves a lot of trouble and buy a low-cost index fund.