Even the Best Mutual Funds Are Not Appropriate for Every Investor.

People often ask the question, which are the best mutual funds? This is almost an impossible question to answer without knowledge of important information such as a person’s time horizon, risk tolerance, preferences, tax situation and other financial circumstances.

The Best Mutual Funds Should Be Consistent with Your Risk Tolerance

The most important factor to consider when providing personalized mutual fund recommendations is a person’s risk tolerance. High-risk/high return mutual funds may be appropriate for an aggressive investor but may not be appropriate for everyone. For example, an emerging markets fund may be the best in its investment category but may not be appropriate for a conservative investor. Similarly, an intermediate bond fund may be the best in its category, but may not be appropriate for an aggressive investor. Unfortunately, far too many people cannot even accurately assess their own risk tolerance. Many people have the tendency to overestimate their willingness to assume risk, especially during periods when stocks are performing well. A perfect example of this overestimation occurred in the late 1990s when technology stocks soared and investors increased allocations to this part of the market. The best time to assess risk tolerance is when markets are falling and investors are more in touch with the reality of losing money.

Which Investment Style Is Best for You?

The best diversified equity mutual funds for one person may also not be appropriate for another person. Some people prefer value mutual funds while other people prefer growth mutual funds. Value-oriented mutual funds tend be less volatile than growth-oriented mutual funds. People who prefer value investments are normally more conservative than those who prefer growth investments. Benjamin Graham, considered by many to be the father of value investing, created the “margin of safety” concept, which embodied the belief that stocks are more attractive when their downside is limited. Conservative investors find a great deal of comfort in believing that their investments have limited downside potential.

Growth investors, on the other hand, are not normally very risk averse and accept high volatility if it is accompanied by high expected returns. Ironically, statistics show that value investments outperform growth investments over long periods of time. Contrary to what some professors teach in business school, tasking more risk does not always result in higher returns.

Which Mutual Fund Size Works Best for You?

An investor’s preference for mutual funds that invest in either large or small companies depends largely on his or her risk and return investment objectives. Small-cap investors are generally looking for high returns and are willing to assume a substantial amount of risk while large-cap investors are generally more conservative and are willing to accept a lower return with less volatility. It is important to note that there are plenty of large-cap mutual funds that are more aggressive and volatile than small-cap mutual funds.