Answers to basic questions about mutual-fund investing

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Alfred from Daytona Beach, Fla., dropped me a note, pointing out that my recent two-part quiz helped him learn about mutual funds, but did not answer his burning question.

"I bet there are a lot of questions that don't really teach people like me how funds work, but which might help us learn how to better work with our funds," Alfred wrote. "Maybe you could answer one of those for me."

He's right, of course. Investing in funds involves more than just knowing how a fund operates. With that in mind, here are a few recent basic questions from readers who wanted to know more about funds than "what's happening now."

I want to put a few hundred dollars into mutual funds for my grandchildren, but my broker tells me that he can't do it in the funds I own now. But there must be a way to open a small account. Can you tell me how to do it?

Alfred, Daytona Beach, Fla.

Many funds waive account minimums for accounts that are registered for children, so start by investigating the funds you currently own (your broker may not be aware of the rules, as many load funds do not normally offer low minimum investments).

What's more, many funds will waive account minimums simply for agreeing to make regular deposits drawn electronically from a bank account. So even if a fund says it has a $10,000 or $25,000 minimum, call its service line to see if the amount can be waived.

If you want to shop low-minimum funds or those that waive minimums, check out the Web site of the Mutual Fund Education Alliance, In the Mutual Fund Center there, the Alliance - a group of companies that sell funds directly to consumers - has a section on funds you can get into for $50 or less, as well as low-minimum funds.

I am a new investor, and I own three funds, two large-cap growth funds and one small-cap. I could invest a little more, and I am wondering if I should put it into the same funds or into something different. ... How many funds should I buy?

Jules, Timonium, Md.

Many life-cycle funds are designed to be a one-size-fits-all asset-allocation option, growing more conservative as the investor ages; you could argue that they are appropriate as a complete portfolio in a single fund.

That said, the key in building a portfolio is diversification and somewhere between four and 12 funds typically will be the right number.

The bigger issue is that proper portfolio construction centers on buying different asset classes, and never holding too many funds in one category. Most studies show that four funds in one category - like large-cap growth - creates a "closet index fund," where the performance tends to mimic an index for that asset type, but the costs are those of active management.

So additional funds make sense, provided they cover bonds, or international stocks, or something not currently represented in the portfolio.

How do I decide if I should take my funds' dividends in cash, or reinvest the money in the fund?

Anonymous e-mail

If you own a fund in a taxable account, you will owe taxes on any payouts you receive whether you take the money or roll it back into the fund, so the decision comes down to a few issues:

1) Do you need the cash? Most equity funds make a payout near the end of the year, and if you will need cash to pay taxes or cover other expenses, taking a distribution in cash certainly beats the accounting headaches that can come from selling shares to scare up liquid assets.

2) Do you want to increase your holdings in the fund? If you need to rebalance - moving some of your cash to an asset class that holds a less-prominent position in your portfolio - or simply want to set a limit because a fund represents too big a chunk of your overall assets, take the money and move it elsewhere.

If you own several funds run by the same firm, find out if the company offers a "cross-reinvestment program." This allows you to take the distribution you get from one fund and automatically roll it into a second fund, a kind of automatic rebalancing plan.

Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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