Picking the right mutual funds for you.

So many choices, so few guarantees. Don't know where to begin? Start right here.

Okay. you've loaded up on advice from friends, family members and personal finance magazines. Enough so, in fact, that your head is beginning to swell from all the mind-blowing information about stocks, bonds and funds.

Nevertheless, you're ready to invest. Like millions of families, you say your investment vehicle of choice is a mutual fund. And why not? Mutual funds are driving the market these days, with a record $251.3 billion flowing into funds in 1993 and total assets approaching the $2 trillion mark, according to Lipper Analytical Services Inc. in New York.

Moreover, companies are increasingly switching to defined-contribution plans, which include 401 (k)s. A peek into these plans nationwide reveals that a quarter of all 401 (k) assets are parked in mutual funds. If you're eligible for your company's plan, then most likely you have your pick of several funds.

That doesn't necessarily help matters much. How do you know which fund is right for you? Should you go with a growth fund or an international fund - or maybe both? Is any one fund enough? With nearly 6,000 funds in the market, how's an investor to pick and choose?

ONE IS NOT ENOUGH

Every savvy saver knows that the core of investing is diversification. Your best shot at raising returns and reducing risk is to own a sundry of mutual funds.

"You want at least four funds in your portfolio," says Walt L. Clark, vice president and investment officer at the Washington, D.C., office of Wheat, First Securities Inc., a Richmond, Va.-based brokerage firm. "You won't be able to diversify with anything less than that."

At the same time, you don't want to overdo it. If you invest beyond 10 funds, you're spreading yourself thin, says Clark. In other words, it would be more prudent to own about 10 funds if you have $100,000 to invest. This way you can up the initial ante of each fund, to about $10,000. It would be much harder to recoup a $10,000 investment with the same number of funds since fees and other expenses would erode your profits.

Even more crucial is how different are the funds, explains A. Michael Lipper, president of Lipper Analytical Services. "The basic benefit of diversifying is to have a good mix across asset classes," he says. So, investing in 10 growth mutual funds won't give you the multiplicity you need as would owning one growth, one international and one income fund.

Yes, the sector you invest in is key to a fund's performance, since it determines a little over 80% of a fund's return over time. But the idea isn't to buy a single sector of the market. Spread your money and your risk across unrelated markets. These might include foreign securities, large capitalization stocks, small company stocks, bonds and real estate.

A good middle-of-the-road portfolio mix: 25% each in a stock fund, balanced fund, bond fund and an international or global fund, advises Charles Ross, an Atlanta-based certified financial planner and nationally syndicated radio show host. With $10,000, you might put $5,000 in an aggressive or growth stock fund, $2,000 in a stock fund that invests overseas, $1,500 in a balanced fund and $1,500 in a bond fund. Anyone in his or her early 20s should consider a portfolio more heavily weighted in aggressive growth stock funds, adds Ross.

Sounds reasonable, right? But what if you have only $1,500 to invest? That doesn't give you much leeway, since most funds have a minimum initial investment of $1,000. Well, there's no shame in building your financial edifice one brick at a time. Read on.

CHOOSING

THE RIGHT FUNDS

Your investment objective plays a major role in picking the best fund(s) for your portfolio. Are you looking for growth, income or just somewhere safe to stash some cash?

Your objective establishes a time frame for investing, and how much time you have to play with dictates how much risk you should take. Risk is normally defined in terms of short-term price volatility and long-term protection of your dollars against the erosion of inflation.

Suppose you are funding a college education for your 13-year-old. With so little time, you may want a conservative fund that will deliver steady performance over the next four years, says Betty Hart, director of public information services for the Washington D.C.-based Investment Company Institute, a national association representing mutual funds.

On the other hand, saving for a retirement that's 20 years away means you can afford to have a more aggressive portfolio because there's plenty of time to recover from down market cycles.

Let's say you're aiming strictly at achieving long-term growth. "That cuts the universe of mutual funds to 473," says Hart. "This type of strategizing will help you better pinpoint the appropriate fund sectors" (i.e., there are roughly 18 long-term fund categories).

Growth funds, for instance, seek capital gains rather than income; income funds tend to invest in stocks and bonds that pay high dividends and interest. Other funds invest in a special sector, such as technology, health care or utilities. Sector funds offer the opportunity of sharp capital gains when that industry is in favor. Of course, that means a major loss if that sector hits a slump.

What if you're among those folks in a high tax bracket? Then you may want to consider tax-exempt bond funds.

So, your mind is made up on which sectors you want. Now what? Start narrowing it down to two or three funds in that area, using these guidelines:

Performance. The most common measure of performance is total returns - dividends, interest, capital gains and changes in share price. But you should look at returns annualized for a specific time period, says John Rekenthaler, editor of the Chicago-based Morningstar Mutual Funds. "It's easier to gauge a fund that has averaged 17% over that last 12 years than simply to say it's been up 300% over the last 12 years."

It's important to measure consistency of performance, says John Markese, president of the Chicago-based American Association of Individual Investors. No doubt, mutual funds should be timed in years, not months or weeks.

"Look for a fund that has done well over the past year, three years and five years," says Markese. Ten years may be stretching it. You can bet that the next 10 years won't look anything like the last 10 years (remember the go-go '80s).

Once you have a particular fund in mind, compare its return against other funds in the same category. An international fund that gained 18% in 1993 may look mighty bright when measured against the S&P 500, up 10%. But 30% was the average for that sector. Now that fund loses some of its shine.

Sales Charges. Hefty charges can turn a winning fund into a mediocre one because expenses eat into your returns. Consider this: A $1,000 investment buys $1,000 worth of no-load fund shares but only $915 worth of shares in a fund with an 8.5% load (sales charge).

Besides, there's no solid evidence that no-load funds, numbered at 1,193, underperform the more costly 1,885 load funds out there. The former has an average return of 11.2%, slightly edging out commission-based funds by 0.1%. Not half bad for funds that allow all your money to go to work for you right away.

But watch out for back-end loads with even the most enticing no-load funds. If you pull out early, for instance, you may get hit with a fee (usually 5% in the first year, then it falls one percentage point after each year you stay in the fund). Some funds also add a marketing charge, known as a 12b-1 fee, that can cost you as much as 2% a year.

There's no guarantee that every fund you favor won't have a load. But, if you really want to get your money's worth, try to get into a fund that charges a low fee, says Michelle A. Smith of Mutual Fund Education Alliance, which publishes The Investor's Guide to Low-Cost Mutual Funds. A low-load fund charges a sales commission of 3.5% or less.

Management Styles. It's also important that you diversify among fund managers as well as categories, says Mark G. Holowesko, portfolio manager for the Templeton World (up 33.6%), Templeton Foreign (up 36.8%) and Templeton Growth (up 32.7%) Funds. The funds you choose within a certain category have different investment strategies. Some strategies may work better in certain markets. "Some fund families (such as Templeton) have pretty much the same investment philosophy for all of their funds," says Holowesko, who has been managing funds since 1987. Other funds are run independently of the company. "So, it's the style of that particular fund's portfolio manager that dictates the investment strategy."

Templeton's philosophy is to look for value. "We look at the share price relative to future earnings," says Holowesko. That also means that the funds he manages invest in emerging markets. The more popular areas are Europe, Latin America and Asia.

A good indicator of a manager's style is a fund's turnover rate. Turnover measures how many times a portfolio manager buys and sells the stocks in a portfolio in the course of a year. A fund with a turnover of 100% in effect changes its holdings completely once a year.

Take the American Heritage Fund. It has a 278% turnover, which means it buys a new portfolio of stocks every four to six months. Any fund that has an excessively high turnover indicates that the manager is primarily a trader rather than an investor.

Subsequently, a lot of buying and selling pushes up the fund's transaction costs. On top of that, if the manager is selling winning stocks, turnover creates short-term capital gains. And short-term gains (those made on assets held for a year or less) are taxed as a part of your income.

One way to check out the style and tenure of a fund's manager(s) is to read its prospectus. In it, you should also find a detailed listing of the fund's holdings. Three other good sources: Morningstar Mutual Funds, Standard & Poor's/Lipper Mutual Fund Profiles and The Value Line Mutual Fund Survey.

Clearly, the Securities and Exchange Commission understands the significance of knowing who's running the fund. The SEC is forcing mutual fund companies to spell out their management style, says Kent Simons, co-portfolio manager of Neuberger & Berman Guardian Fund (up 14.45%).

"We like to buy stocks that are out of favor and are paying 30% less than the market," says Simons, who runs the $2 billion fund together with Larry Marx III. The Guardian Fund holds about 100 stocks; among Simons' favorites are Fannie Mae, AT&T and NationsBank.

Since 1983, Ariel Capital Management Inc. in Chicago, the nation's premier black-managed mutual fund company, has counseled the same patient strategy of investing in undervalued stocks. The company's Calvert-Ariel Appreciation Fund, which averages 12.4%, has some 50 holdings, including Carnival Cruise Lines, American Greetings and Hasbro.

Traditionally, value investors purchase big blue-chip companies that fall into disfavor, while small-company investors buy fast-growth companies. "We try to get the best of both worlds - smaller, undiscovered companies that are selling at reasonable prices," says John W. Rogers Jr., Ariel's founder and president.

Keep in mind, though, that investments will vary widely even among the most adroit managers. Any of the leading mutual funds will work in your favor. The biggest payoff will come from diversification and prudence - the only hedge against today's top funds becoming tomorrow's flops.