Are You Making These Mistakes When Buying Mutual Funds?

If you have decided to begin investing and want to look into mutual funds, it can be confusing trying to decide where to start. There are thousands of active mutual funds available for investors to choose from. It can also be hard to determine when the best time to buy a mutual fund is.

One of the best steps you can take as a new investor is to learn what you should avoid. Understanding the following concepts can help you avoid losing large amounts of money before you are knowledgeable about investing in mutual funds.

Chasing High Fee, Past Performance All-Stars

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Many finance magazines have to sell subscriptions and advertising—and to do so, they use headlines like “Top 10 Funds to Own This Year." The editors and journalists do not necessarily know if these funds will make you money. No one actually knows if these funds will make you money in the upcoming year. There are factors, however, that have been proven to deliver over time, and being on someone's top ten list is usually not one of them.

For example, Morningstar—a company that does research on mutual funds—notes that the single biggest predictor of top-performing funds was not their own rating system of assigning stars, but the fund's fees. Lower fees tended to directly correlate with higher-performing funds. Index funds—funds that are structured around an index, such as the Standard & Poor's 500 Index—generally have the lowest fees.

Note

A stock index is a list of stocks chosen for their performance by index managers.

Why do lower fee funds fare well over time? It's because higher-fee funds typically take an actively managed approach, where the fund pays a team of analysts and a fund manager to try to pick the highest returning investments at that time. Because the fund has to pay the fund managers, the fees are higher.

While it is possible for higher-fee funds to perform well, you have to decide whether the fees and risk of chasing the latest and greatest returns are worth it.

The top performers one year can perform the following year, but generally speaking, this doesn't usually happen. Market fluctuations, economic circumstances, and investor sentiment and interests cause investment returns to rise and fall. Lower-fee funds, as passively managed funds, do not fluctuate as wildly as the rest of the market because they are made up of investments that have proven to be more stable in their returns, and they are not continuously turning over assets in favor of "the next-greatest investment."

Warning

Actively managed funds typically chase the funds that are being recommended by others, and high turnover rates within the funds themselves. A high turnover rate generally means higher taxes and fees for investors.

Actively managed funds are also less tax-efficient. Because these funds actively sell and buy investments, they generate more short-term capital gains—which are taxed as normal income—rather than long-term capital gains, which are taxed at a lower rate. If you find an actively managed fund you want, it might be best to own it an IRA or other tax-deferred account where you won't get hit by large short-term gain distributions each year.

Buying Funds With Embedded Capital Gains

Suppose you buy a mutual fund in October. In December, that mutual fund sells a stock it has owned for 10 years. A pro-rata portion of that gain is then distributed to all current shareholders of the mutual fund. This means that you are paying taxes on a gain that occurred within a fund that you have owned for only a short time, making it taxable income.

If the shares have lost value, you'll be paying taxes for losing money, even though you received a distribution. You can avoid this by purchasing mutual funds in a non-retirement account, tax-managed fund, index fund, or exchange-traded funds (ETF).

Note

Inside of retirement accounts like IRAs, 401(k)s, 403(b)s, and other company retirement plans—regardless of the transactions that occur within or between the investments in the plan—you pay no taxes until you withdraw funds.

At the end of each year, you might also harvest losses by realizing a capital loss for tax reasons if you exchange one mutual fund for another.

Buying Many Similar Fund Strategies

Many people own eight to 10 different mutual funds and think they are diversified—but if they were to look inside the mutual funds, they would find all the holdings are in the same type of stock or bond. This is akin to sitting down to eat a well-balanced meal and finding only pork, beef, and chicken.

A well-diversified portfolio gives you exposure to large market capacity (large-cap) stocks, small market capacity stocks (small-cap) stocks, international large-cap stocks, international small-cap stocks, real estate stocks, emerging markets, and various types of bonds.

Before you buy shares of a mutual fund, look at the ingredients. Does the fund own something different than other funds you own? If so, it may be a good addition to your portfolio.

If you're not sure what holdings are in the fund, seek professional guidance, or use a balanced fund or target-date fund, as these types of funds automatically spread your investment out over a diversified set of holdings.

Having Your Investment Income Taxed Like Ordinary Income

When you sell shares of a mutual fund that you have owned for at least 12 months, and they are worth more than you paid for them, the gain is taxed as a long-term capital gain. You pay taxes on long-term capital gains at a lower tax rate than the rate charged on ordinary taxable income and interest income. This is because the IRS views short-term gains—less than 12 months—as annual income.

However, if that capital gain is occurring in your tax-deferred retirement account, you don't get to take advantage of the lower long-term capital gains tax rates. When you eventually withdraw from the tax-deferred retirement account, everything that comes out will be taxed at the same rate as earned income.

To keep taxes as low as possible—sometimes referred to as keeping your investments tax-efficient—you can use a technique called "asset location." This is the process of deciding how to tax-efficiently locate certain asset classes across tax-deferred accounts (like IRAs and 401(k)s, tax-free (Roth) accounts, and taxable accounts (brokerage and mutual fund accounts). Bond funds might be best suited for tax-deferred retirement accounts and stock index funds for non-retirement accounts.

Focusing on the Fund Rather Than Your Goals

A mutual fund can result in a great success story for many investors. However, the story should generally be quite long and boring to be truly beneficial because mutual funds are most commonly used as long-term "growth" investment vehicles.

Many of the most successful investors focus on their long-term goals by carefully defining how their investment story should end, and by defining the role each investment plays in the story. Speculators run to the popular "best investments" rather than masterminding the plot for themselves.

You should purchase your mutual funds when it is right for you and at the right price for your circumstances and goals. You might be able to time your purchases right, such as buying them at one of the lower points of a market downswing when prices should begin to rise.

By timing purchases, investing rather than speculating, understanding how fees work, and knowing when and how you can be taxed, you can maximize your returns and minimize your losses.

Good investments are not the ones that everyone is raving about—they are the investments that are good for your plan, experience, and long-term goals.