If you have made a decision to include mutual funds in your investment strategy but don't know how to get started, it's actually pretty easy with just a bit of due diligence on your part. You can get halfway there just by understanding your own tolerance for risk and getting clear on your investment objectives. Picking winning mutual funds involves choosing those that provide good returns at a low cost, but funds are even bigger "winners" when they strategically enhance your own portfolio and investing objectives.
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.
Start With Your Goals and Risk Tolerance
When three Boston money managers pooled their money in 1924, the first mutual fund was born. In the subsequent nine decades, that simple concept has grown into one of the biggest industries in the world, now controlling trillions of dollars in assets and allowing small investors a means to compound their wealth through systematic investments via a dollar cost averaging plan. In fact, the mutual fund industry has spawned its own stars with cult-like followings: Peter Lynch, Bill Gross, and Marty Whitman, and the folks at Tweedy, Browne & Company just to name a few.
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.
Pay Attention to the Expense Ratio—It Can Make or Break You!
It takes money to run a mutual fund. Things such as copies, portfolio management, analyst salaries, coffee, office leases, and electricity have to be taken care of before your cash can even be invested! The percentage of assets that go toward these things—the management advisory fee and basic operating expenses—is known as the expense ratio.
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 percent and 1.5 percent, 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.
Avoid Mutual Funds With High Turnover Ratios
It’s important to focus on the turnover rate—that is, the percentage of the portfolio that is bought and sold each year—for any mutual fund you are considering. The reason is that age-old bane of our existence: taxes.
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 percent or more of their portfolio.
Look for an Experienced, Disciplined Management Team
In this day of easy access to information, it shouldn’t be hard to find information on your portfolio manager. If you find yourself holding a mutual fund with a manager that has little or no track record or, even worse, a history of massive losses when the stock market as a whole has performed well, consider running as fast as you can in the other direction.
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.
Find a Philosophy That Agrees With Your Own
Like all things in life, there are different philosophical approaches to managing money. Many people, like Warren Buffett, are value investors. Over time, they look for businesses that they believe are trading at a substantial discount. As a result, they buy very few businesses each year and, over time, can lead to very good results.
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.
Buy No-Load Mutual Funds
Some mutual funds charge what is known as a sales load. This is a fee, usually around 5 percent of assets, that is paid to the person who sells you the fund. It can be a great way to make money if you are a wealth manager, but if you are putting together a portfolio, you should only buy no-load mutual funds. Why? It's simple math!
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 percent sales load, your account balance will start at $94,250. Assuming an 11 percent 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. So, always buy no-load mutual funds.
Know the Appropriate Benchmark for Your Mutual Funds
Each fund has a different approach and goal. That’s why it’s important to know what you should compare it against to know if your portfolio manager is doing a good job. For example, if you own a balanced fund that keeps 50 percent of its assets in stocks and 50 percent in bonds, you should be thrilled with a return of 10 percent even if the broader market did 14 percent. Adjusted for the risk you took with your capital, returns were stellar!
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.
Work Toward Ample Diversification of Assets
Warren Buffett, known for concentrating his assets into a few key opportunities, has said that for those who know nothing about the markets, extreme diversification makes sense. It’s vitally important that if you lack the ability to make judgment calls on a company’s intrinsic value, you spread your assets out among different companies, sectors, and industries. Simply owning four different mutual funds specializing in the financial sector, for example, is not diversification. Were something to hit those funds on the scale of the real-estate collapse of the early 1990’s, your portfolio would be hit hard.
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.
The Case for Index Funds
For the average investor who has a decade or longer to invest and wants to regularly put aside money to compound over time, index funds can be a great choice. They combine almost unfathomably low turnover rates with rock-bottom expense ratios and widespread diversification; in other words, you really can have your cake and eat it, too.
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.
When you invest outside of the U.S., the costs are higher. But in the past, stocks of foreign countries have shown low correlation with those in the United States. When constructing portfolios designed to build wealth over time, the theory is that these shares aren’t as likely to be hit hard when the American equities are crashing (and visa versa.)
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.
Use Dollar Cost Averaging
You may have heard this multiple times, but dollar cost averaging really is the single best way to lower your risk over long periods of time and help lower your overall cost basis for your investments.
It consists of making regular periodic investments, usually of the same amount, into one or more mutual funds of your choice. Say, 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, this keeps the average cost basis of your shares lower, and you can build a larger stock position without feeling the effects in your wallet.
There are a ton of great resources out there about choosing and selecting a mutual fund including the Mutual Fund site which goes into much greater depth on all of these topics and more. Morningstar is also an excellent resource.
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 moving in and out of funds, incurring frictional expenses and triggering tax events.