Mutual funds offer small investors a way to participate in the financial markets. But, in order to earn a fair return, investors need to do their homework. Evidence shows that most investors do poorly because they select inappropriate funds and trade them at the wrong times. To help you avoid this fate, we offer you some pointers for selecting funds and earning a competitive return.
- Determine your portfolio strategy first; then select funds to build your portfolio. These funds should provide wide diversification across different categories of stocks, bonds and other securities.Your strategy should consider:
a. How long will you hold the investments
(that is, how long it will be before you will need the cash),
b. How much you will need to draw, and
c. How much risk you can tolerate and still sleep at night.
Your strategy should not be to find the “hot” fund that had the highest return last year—the one everyone is talking about. Such funds are not likely to remain at the top for long.
- Stick to your strategy through thick and thin. John Bogel, the founder of Vanguard Mutual Funds, has noted for years that the average investor earns much less than the average mutual fund. The reason for this poor performance is that the average investor buys hot funds when the market is high, then sells when the market is low. The best strategy is not to change course in midstream.
- Select funds with low costs. Over the long run, the costs of mutual funds add up, and research has shown that expensive funds perform worse than less expensive ones. Make sure your funds are “no-load funds,” which have no front-end loads (commissions paid when you buy a fund) or back-end loads (commissions paid when you sell a fund). Make sure the funds’ operating expenses are less than 1.4% per year, the average cost of all mutual funds.
- Pick funds with clear, consistent investment styles that fit your investment strategy. Make sure the fund really owns securities consistent with its stated style. Often the name of a fund gives a poor description of how a fund really invests your money. Watch out for “style drift.” Sometimes a fund will start out with one style, but then the types of investments it holds gradually drift to a different style. The Fidelity Magellan Fund was a classic example: it changed from a growth stock fund to a balanced fund holding both stocks and bonds.
- Select funds from well-established and respected fund families.
- Select funds that have managers with at least 3 years of tenure.
- Choose funds that have been in the top 25% of their peer groups over 5 years. If the fund is a small-cap growth stock fund, you should see how its rate of return compares with those of other small-cap growth stock funds.
- Watch out for high cash balances. Mutual funds often keep cash balances so they will be prepared for investor withdrawals. The problem is that not all of your money is working for you.
- Avoid funds that have “high turnover rates,” which means they buy and sell often. Trading stocks rapidly increases costs and causes more taxable gains in taxable accounts.
- Minimize portfolio overlap. Often mutual funds buy the same stocks. This means you may not be as diversified as you think you are.
- Avoid the largest funds: funds over $10 billion.
To gather these facts, do not depend on the prospectus alone. Often the description in the prospectus is purposely vague, which allows the managers to do almost anything they want. Therefore, you should also contact the mutual fund company or look the fund up onMorningstar.com. Or, you can call BWFA to help you with these decisions.