Once you’re ready to choose some mutual funds, there are ways to analyze them, such as looking at each fund’s past performance history, management team, and expense ratios. You can also entertain different investment strategies that will drive your fund choices, such as diversifying your portfolio with international exposure, buying the market index (S&P 500), or dollar-cost-averaging your money into different funds. As an investor, you’ll have upwards of 10,000 mutual funds from a plethora of fund management companies to choose from, so it helps to set some goals to narrow the field. Ask yourself the following questions to gain some clarity on your investing goals:
Are you looking for current income or long-term appreciation (capital gains)?Does the money need to fund a college education or accumulate for a far-off retirement?
In terms of risk tolerance, it’s important to decide where you sit on the risk continuum:
Can you tolerate a portfolio that may have extreme ups and downs?Are you more comfortable with a conservative investment strategy?
Finally, think about the best time horizon for your investments, or how long you need to invest your funds:
Do you need your funds to be liquid in the near future?Are you investing money that you can afford to have tucked away for many years?
If you invest in mutual funds that have sales charges, they can add up if you’re investing for the short term. An investing term of at least five years is ideal to offset these charges. In short, it is the cost of owning the fund. Think of it as the amount a mutual fund has to earn just to break even before it can even begin to start growing your money. All else being equal, you want to own funds that have the lowest possible expense ratio. If two funds have expense ratios of 0.50% and 1.5%, respectively, the latter has a much bigger hurdle to beat before money starts flowing into your pocketbook. Over time, these seemingly paltry percentages can result in a huge difference in how your wealth grows. If you are investing solely through a tax-free account such as a 401k, Roth IRA, or Traditional IRA, this is not a consideration, nor does it matter if you manage the investments for a non-profit. For everyone else, however, taxes can take a huge bite out of the proverbial pie, especially if you are fortunate enough to occupy the upper rungs of the income ladder. You should be wary of funds that habitually turnover 50% or more of their portfolio. The ideal situation is a firm that is founded on one or more strong investment analysts/portfolio managers that have built a team of talented and disciplined individuals around them that are slowly moving into the day-to-day responsibilities, ensuring a smooth transition. It is in this way that firms such as Tweedy, Browne & Company in New York have managed to turn in decade after decade of market-crushing returns while having virtually no internal upheaval. Finally, check to see if the managers have a substantial portion of their net worth invested alongside the fund holders. It’s easy to pay lip service to investors but it’s a different thing entirely to have your own capital at risk alongside theirs. In the industry, there are mutual funds that specialize in this type of value investing, such as Tweedy, Browne & Company, Third Avenue Value Funds, Fairholme Funds, Oakmark Funds, Muhlenkamp Funds, and more. Other people believe in what is known as “growth” investing which means simply buying the best, fastest growing companies almost regardless of price. Still others believe in owning only blue-chip companies with healthy dividend yields. It is important for you to find a mutual fund or family of mutual funds that shares the same investment philosophy you do. Imagine you have inherited a $100,000 lump sum and want to invest it. You are 25 years old. If you invest in no-load mutual funds, your money will go into the fund and every penny—the full $100,000—will immediately be working for you. If, however, you buy a load fund with, say, a 5.75% sales load, your account balance will start at $94,250. Assuming an 11% return, by the time you reach retirement, you’ll end up with $373,755 less money as a result of the capital lost to the sales load. Always buy no-load mutual funds. Some popular benchmarks include the Dow Jones Industrial Average, the S&P 500, the Russell 2000, the Nasdaq Composite, and the S&P 400 Midcap. It’s easy to search online to see what benchmarks funds are tied to. You can then research reports on various funds and find out how they evaluate them, view historical data, and even get their analyst’s thoughts on the quality and talent of the portfolio management team. What is considered good diversification? Here are some rough guidelines:
Don’t own funds that make heavy sector or industry bets. If you choose to, despite this warning, make sure that you don’t have a huge portion of your funds invested in them.Don’t keep all of your funds within the same fund family. By spreading your assets out at different companies, you can mitigate the risk of internal turmoil, ethics breaches, and other localized problems.Don’t just think stocks. There are also real estate funds, international funds, fixed income funds, arbitrage funds, convertible funds, and much, much more. Although it is probably wise to have the core of your portfolio in domestic equities over long periods of time, there are other areas that can offer good returns.
Check out Vanguard and Fidelity as they are the undisputed leaders in low-cost index funds. Typically, look for an S&P 500 fund or other major indexes such as the Wilshire 5000 or the Dow Jones Industrial Average. First, if you are going to venture into the international equity market by owning a fund, you should probably only own those that invest in established markets such as Japan, Great Britain, Germany, Brazil, and other stable countries. The alternatives are emerging markets which pose far greater political and economic risk, though they do offer potentially higher returns. It consists of making regular periodic investments, usually of the same amount, into one or more mutual funds of your choice. Suppose, for example, that you invest $100 each month into mutual funds. When the market is up, your $100 buys fewer shares, but when the market is down, you get more shares for the same money. Over time, that keeps the average cost basis of your shares lower, and you can build a larger stock position without feeling the effects in your wallet. Just remember that the key is to remain disciplined, rational, and avoid being moved by short-term price movements in the market. Your goal is to build wealth over the long term. You simply can’t do that by moving in and out of funds, incurring frictional expenses and triggering taxable events.
