How to Pick a Good Mutual Fund
Are you thinking about investing in a mutual fund, but aren't sure how to go about it or which one is the most appropriate based on your needs? You're not alone. However, what you may not know is that the selection process is much easier than you think.
Identifying Goals and Risk Tolerance
Before acquiring shares in any fund, an investor must first identify his or her goals and desires for the money being invested. Are long-term capital gains desired, or is a current income preferred? Will the money be used to pay for college expenses, or to supplement a retirement that is decades away? Identifying a goal is important because it will enable you to dramatically whittle down the list of the more than 8,000 mutual funds in the public domain.
In addition, investors must also consider the issue of risk tolerance. Can the investor afford and mentally accept dramatic swings in portfolio value? Or, is a more conservative investment warranted? Identifying risk tolerance is as important as identifying a goal.
Finally, the issue of time horizon must be addressed. Investors must think about how long they can afford to tie up their money, or if they anticipate any liquidity concerns in the near future. This is because mutual funds have sales charges and that can take a big bite out of an investor's return over short periods of time. Ideally, mutual fund holders should have an investment horizon of at least five years.
Style and Fund Type
If the investor intends to use the money for a longer-term need and can handle a fair amount of risk and volatility, then the best bet may be a long-term capital appreciation fund. These types of funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be volatile in nature. They also carry the potential for a large reward over time.
Conversely, if the investor is in need of current income, he or she should acquire shares in an income fund. Government and corporate debt are two of the more common holdings in an income fund.
Of course, there are times when an investor has a longer-term need, but is unwilling or unable to assume substantial risk. In this case, a balanced fund, which invests in both stocks and bonds, may be the best alternative.
Charges and Fees
Mutual funds make their money by charging fees to the investor. It is important to gain an understanding of the different types of fees that you may face when purchasing an investment.
Some funds charge a sales fee known as a load fee, which will either be charged upon the initial investment or upon the sale of the investment. A front-end load fee is paid out of the initial investment made by the investor, while a back-end load fee is charged when an investor sells his or her investment, usually prior to a set time period, such as seven years from purchase.
Both front- and back-end loaded funds typically charge 3% to 6% of the total amount invested or distributed, but this number can be as much as 8.5% by law. Its purpose is to discourage turnover and to cover any administrative charges associated with the investment. Depending on the mutual fund, the fees may go to a broker for selling the mutual fund or to the fund itself, which may result in lower administration fees later on.
To avoid these sales fees, look for no-load funds, which don't charge a front- or back-end load fee. However, be aware of the other fees in a no-load fund, such as the management expense ratio and other administration fees, as they may be very high.
Other funds charge 12b-1 fees, which are baked into the share price and are used by the fund for promotions, sales and other activities related to the distribution of fund shares. These fees come right off of the reported share price at a predetermined point in time. As a result, investors may not be aware of the fee at all. The 12b-1 fees can be, by law, as much as 0.75% of a fund's average assets per year.
One final tip when perusing mutual fund sales literature: The investor should look for the management expense ratio. In fact, that one number can help clear up any and all confusion as it relates to sales charges. The ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower the investor's return will be at the end of the year.
Evaluating Managers and Past Results
As with all investments, investors should research a fund's past results. To that end, the following is a list of questions that prospective investors should ask themselves when reviewing the historical record:
Did the fund manager deliver results that were consistent with general market returns?
Was the fund more volatile than the big indexes (meaning did its returns vary dramatically throughout the year)?
Was there an unusually high turnover (which can result in larger tax liabilities for the investor)?
This information is important because it will give the investor insight into how the portfolio manager performs under certain conditions, as well as what historically has been the trend in terms of turnover and return.
With that in mind, past performance is no guarantee of future results. For this reason, prior to buying into a fund, it makes sense to review the investment company's literature to look for information about anticipated trends in the market in the years ahead. In most cases, a candid fund manager will give the investor some sense of the prospects for the fund and/or its holdings in the year(s) ahead as well as discuss general industry trends that may be helpful.
Size of the Fund
Typically, the size of a fund does not hinder its ability to meet its investment objectives. However, there are times when a fund can get too big. A perfect example is Fidelity's Magellan Fund. Back in 1999 the fund topped $100 billion in assets and it was forced to change its investment process to accommodate the large daily (money) inflows. Instead of being nimble and buying small- and mid-cap stocks, it shifted its focus primarily towards larger capitalization growth stocks. As a result, its performance suffered.
So how big is too big? There are no benchmarks that are set in stone, but that $100 billion mark certainly makes it difficult for a fund manager to acquire a position in a stock and dispose of it without dramatically running up the stock on the way up and depressing it on the way down. It also makes the process of buying and selling stocks with any kind of anonymity almost impossible.
The Bottom Line
Selecting a mutual fund may seem like a daunting task, but knowing your objectives and risk tolerance is half of the battle. If you follow this bit of due diligence before selecting a fund, you will increase your chances of success.
The 3 Most Timeless Investment Principles
Warren Buffett is widely considered one of the greatest investors of all time, but if you were to ask him whom he thinks is the greatest investor, he would probably mention one man: his teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered the father of security analysis and value investing.
His ideas and methods on investing are well documented in his books "Security Analysis" (1934) and "The Intelligent Investor" (1949), which are two of the most famous investing texts. These texts are often considered requisite reading material for any investor, but they aren't easy reads. In this article, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.
Principle #1: Always Invest with a Margin of Safety
Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for 50 cents. He did this very, very well.
To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the total market cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham.
This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.
While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety."
Principle #2: Expect Volatility and Profit from It
Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market," the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business's prospects and quotes a low price.
Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate, sometimes wildly, but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.
Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:
Dollar-Cost Averaging
Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions.
Investing in Stocks and Bonds
Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25% to 75% of your investments in bonds and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating).
Principle #3: Know What Kind of Investor You Are
Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.
Active vs. Passive
Graham referred to active and passive investors as "enterprising investors" and "defensive investors."
You only have two real choices: the first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive (possibly lower) return, but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "work = return." The more work you put into your investments, the higher your return should be.
If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return, such as the return of the S&P 500, is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.
In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market.
Speculator vs. Investor
Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing; the key is to be sure you understand which you are good at.
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