How to pick the right funds for you – and what experts recommend (whether you’re starting out or nearing retirement)

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When it comes to investing, one of the golden rules is to not put all your eggs in one basket.

Investing in funds and trusts can help to diversify your portfolio but with so many on offer, it can be difficult to know where to start.

Each fund offers something different and what might work for one investor might not work for another.

What’s right for you will depend on your personal financial situation, your risk appetite - essentially how much risk you’re willing to take with your investments - and what stage you are at in your investment journey.

We look at how you might assess all this and how you can find the best funds for your goals.

Risk appetite: The right fund will depend on your personal situation and what stage you're at 

How to work out what your investment style is

Once you’ve decided to invest and know how much money you want to commit, either in a lump sum or as a regular investment, you then need to work out what to invest in.

Investors have a choice between passive investments, which are designed to track the price of a set index of assets, for example a stock market index like the FTSE All Share, or active investments, where a manager seeks to pick investments they think will beat the market.

Investment trusts and funds, whether passive or actively managed, are a good way to start, as they pool your money with other people’s and invest across a basket of assets – doing some of the work of diversification for you.

The first thing you should consider when deciding on which fund or trust to invest in is how much risk you are willing to take.

This will help you to narrow your focus and make the decision-making process much easier.

In investing, there are different levels of risk, with the three main categories being cautious, balanced and adventurous.

Generally, investments with a higher level of risk usually have the potential to deliver a higher rate of return but there are no guarantees.

If you’re a more ‘adventurous’ investor you’re likely to ride the volatility of the stock market, as these types of funds can invest up to 90 per cent of the portfolio into equities, the investment term for company shares.

If you’re not prepared to deal with some of the ups and downs associated with a higher risk fund, you might opt for a lower, but steadier return.

Cautious funds usually have a lower exposure to shares and are more invested in bonds, which involve lending companies or governments money and offer a fixed rate of return over their lifetime.

While a bond’s interest payment is fixed, bond prices can move over their duration, which is the lifetime of the bond, for example five years.

Traditionally bond prices are seen as having an inverse relationship with the stock market. Investment theory says this means that they are better equipped to protect your investments in the event of a market downturn. It’s worth noting that isn’t guaranteed to always be the case.

‘The trade-off, however, is that when stock markets rise, funds that are more cautiously positioned will produce more modest returns,’ says Kyle Caldwell, collectives editor at interactive investor.

A cautious fund is not just one that has lower returns, instead it should be protecting an investor from volatility and this is something you should consider when creating your portfolio.

While fixed income investments tend to feature heavily in cautious funds, they also invest in defensive equities in sectors like consumer staples or healthcare.

Balanced funds sit between the two, so when markets rise they are usually positioned to outperform cautious funds, but probably won’t do as well as adventurous funds.

A balanced fund usually allocates between 50-70 per cent of a portfolio into equities, with the remaining portion into bonds.

When markets are in a downturn, a balanced fund can help to limit losses more than higher-risk funds but not protect as much as a cautious fund.

‘A balanced fund may fit the bill for those who want to sleep easy at night, but at the same time would like to aim for higher growth than a cautious fund,’ says Caldwell.

What kind of fund should I opt for?

The approach you take is entirely personal and it can change over time depending on your circumstances.

If you’re in your 20s or 30s, you are likely to take a different approach to someone nearing retirement, as you have a much longer investment time horizon, and can likely afford to be a bit more adventurous.

This is because younger investors who will potentially be investing for 30 to 40 years have a longer period ‘to ride out the inevitable short-term swings that come with the territory of stock market investment,’ says Caldwell.

For those approaching retirement, or close to reaching their target towards investing for a specific goal like buying a home, they might opt for a cautious fund to limit their potential losses if the market takes a sudden downturn.

Caldwell also suggests that you might consider funds that closely match your personality type.

‘If you are a glass half-empty type of person, you may be more concerned than others about the risks of your investments suffering losses. Whereas if you are more of a thrill-seeker you may be prepared to be more adventurous.’

> For more investing ideas and insight, visit ii.co.uk 

How experts pick the best funds

Once you’ve worked out how much risk you’re willing to take with your investments, you can start shopping around for different funds that fall within these risk levels.

If this sounds daunting, lots of investment platforms have ‘best buy’ lists, which cut out some of the complexity and present the top funds to everyday investors.

Even if you choose not to go for one of these ‘best buys’ it is worth applying some of the methodology used by these platforms to help narrow down your choices.

Interactive Investor’s Super 60 list includes a range of active funds, investment trusts and passive investments like index funds and exchange-traded funds (ETF).

Chiefly, you’ll want to look at how the fund has performed over the long term, not just the past year, for example, over the past three, five or ten years

This is important to work out whether it has consistently performed in line with or below the benchmark, which can help you decide whether you want to invest.

They also profile funds according to their risk and eliminate funds with poor risk characteristics, including those run by managers who take inappropriately high risks.

You’ll also want to consider costs, which can vary from fund to fund. Interactive Investor avoids investments where there is an initial charge, and the Ongoing Charges Figure (OCF) must be good value and not significantly higher than its peer group average.