Selecting mutual funds is far less involved than selecting individual stocks. Because mutual funds invest in a wide variety of stocks (or bonds, or other
asset classes), virtually any mutual fund will provide about the
return of the market minus fees and trading expenses. The main
things to consider when selecting a mutual fund are therefore
expenses and investment objectives.
Investment fees, including fees when shares are purchased or redeemed – called the “load”, and yearly operating fees and expenses, are important
considerations. In general, because most mutual funds will track the
market over long periods of time minus fees and expenses, minimizing
fees and expenses will maximize returns.
In selecting mutual funds, many people would buy the one that performed the best over the last year or two.
After all, that manager might have some secrets that allow him to
generate those 20% returns. Why would someone want to settle for a
paltry 5% return when one could get 20%?
One must be careful to read that little
disclaimer that is at the bottom of all mutual fund advertisements:
“Past performance may not be indicative of future results.” Just
because a stock fund or a sector of the market does well a certain
year does not mean that it will continue to outperform its peers. In
fact, because the fund has done well it is more likely that the
stocks in the fund will be overpriced and that it will lag its peers
the next year. Likewise, just because a stock fund does poorly in
any given year does not mean that it will do poorly the next year.
It is the result of this chasing performance that most people buy
funds right before they are ready to fall off and sell them just
before they are ready to shoot up.
Rather than using past performance in selecting mutual funds, one should consider the following:
1) Check the fees compared to other
similar funds. If fees are high (greater than 1%), it would be wise
to change to a less expensive fund in the same sector. Index funds
tend to have very low fees.
2) Evaluate the segment of the market
in which the fund invests and decide if it si a sector in which you
wish to be invested. If you are in an emerging markets fund the
performance will likely be all over the board with some spectacular
years and some dismal years. If you buy a bond fund it will not
perform as well as a stock fund over a long period of time, but int
he bad years it will probably hold up better. For example, in 2008
stocks fell more than 20% while bond funds generally had a positive
return. It is therefore a good idea to own funds in different
segments of the market with the balance depending on how long you
have to invest the money.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.