Joel D. Kinard CISSP, CIAM, EIT
205 Airport Road
Monroe , NC 28110
Email address: jdkinard@gmail.com


Principles for Investing in Mutual Funds

Don't make mutual fund investing more complicated than it needs to be. Here are seven time-tested principles for investing in mutual funds.

1) Goals
2) Diversify
3) Performance
4) Risk
5) Funds Costs
6) Taxes
7) Selling

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1) Choose Funds That Suit Your Goals - don't commit another dollar to the market until you commit yourself to your goals. Start by writing them down. You'll be surprised to find how much easier choosing the right mutual funds can be once you settle in on how much you'll need to accumulate and when you'll need the money.

Before you make any investment, you should consider why you are investing. Are you trying to build wealth to meet long-term goals such as a retirement that is decades away? Are you investing towards college tuitions that are almost around the corner? Are you trying to generate income to pay current expenses?

Chances are, you have several goals, and each fund you buy should aim to match at least one of them.

The most important consideration is time. Even if you are a conservative investor you may not want to limit yourself to bond funds if you can afford to hold your investment for ten years or more. As a rule of thumb, domestic stock funds are designed to help your money grow to meet longer-term goals. On the other side of the spectrum, bond funds typically seek to generate current income for today's expenses.

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2) Make Every Fund Part of an Asset Allocation Plan - Each new fund you buy alters your asset allocation (variety of assets contained in an investment portfolio). If you haven't developed an asset allocation plan yet, why wait?

Your investment plan should include a mix of investments from different sections of the financial markets. That way, your financial future won't depend upon the success or failure of any one type of fund or investment.

When you choose a new fund for your portfolio, make sure that it works well with the current mix of funds and asset categories in your portfolio. For example, let's say you are investing for growth and already own several funds that invest in shares of big, blue chip domestic companies. It might make sense to add funds that invest in shares of small companies or overseas firms rather than buy yet another blue chip fund.

Your portfolio also should include funds with a variety of investment strategies, or styles. For example, you might own shares in several growth-oriented funds that invest in fast growing companies, as well as value-oriented funds that favor neglected stocks trading at bargain prices.

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3) Investigate a Fund's Performance Figures - Resist the siren song of short-term performance with all your willpower! Look for funds (and fund managers) that have distinguished themselves over the long haul, through both up and down markets.

Big investment returns can be impressive-but they also can be misinterpreted. Carefully consider what a fund's performance numbers really mean. Here's how to do that:

Look beyond recent gains or losses. Don't buy a fund just because it's had a recent hot streak. Look for consistent results over longer periods - say five years - and in different market environments.

Compare apples to apples. Before you buy a fund with seemingly strong record, ask how it has performed compared to other funds in the same category that invest in similar types of securities. For example, don't compare large cap value funds with small cap growth funds or world funds. While past performance does not predict future results, if a fund consistently beats the competition over standard periods of time, you may have found the right fund.

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4) Risk Matters as Much as Return - In fact, risk can't truly be separated from return-they're closely related. Want higher returns? You'll generally need to accept more risk (wider fluctuations in prices). But time can mitigate risk, while a good asset allocation plan can help you sidestep unnecessary risk.

No investment should cause you to lose even a moment's sleep. Before you invest in a fund consider these three factors:

First, how much risk does a fund carry? A funds' past performance can offer some clues about how it may behave over time. Pay careful attention to its returns during periods when the financial markets have stumbled and recovered. Also examine the fund prospectus for information about risk factors associated with its investment strategy.

Second, how does the fund affect your portfolio's overall risk? Consider how a new fund will interact with other funds to determine that risk. For example, an international stock fund might seem quite risky on its own. But adding that fund to a portfolio of domestic stock funds might reduce the risk that your portfolio will suffer losses in a market downturn that primarily affects U.S. stocks.

Third, can you tolerate that risk? If you are investing primarily toward long-term goals, you can afford the time to ride out some fluctuations in the value of your savings. By contrasts, if you need access to your money soon, then you may not want to risk even a temporary decline in the value of your fund investments.

International funds are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Funds that invest in small company stocks are subject to the greater volatility than funds in other domestic asset classes.

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5) Consider Fund Costs - Any loads or fees lower your overall returns. Consider this: $10,000 at 10% interest over 30 years grows to nearly $175,000. That same $10,000 at 10.5% interest, just one-half percent more, grows to $200,000. In the long run, every percentage point counts.

When you're researching a fund's performance numbers, also consider another set of figures: the expenses that will reduce your potential returns. The most important costs to consider are these:

Loads. Many funds carry initial sales charges, or "loads." When you pay a load, only part of your initial investment goes to work for you in the fund. That said, some load funds are worthwhile investments - and some no-load funds are not. Best advice: Don't pay a load until you have considered no-load options.

Operating expenses. Funds charge fees to cover management and other costs. Typically, those fees are higher for stock funds than for bond funds - but there are wide differences within each category. All else being equal, lower expenses translate into higher returns.

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6) Taxes Matter - Most funds tout pre-tax returns, even though after-tax returns gauge what you actually get to keep. Unfortunately, post-tax returns are difficult to measure. But that doesn't mean they're not of crucial importance to you.

The right planning can ensure that more of your funds' investment returns end up in your pocket rather than the government's coffers. So ask these tax-related questions before you invest in a fund:

Will the fund primarily generate dividends or capital gains? Dividends from fund generating income are generally taxed at a higher rate than the capital gains that come from selling a security at a profit. The difference can have a big impact on your long-term returns.

Are any of the fund's returns tax-exempt? If you are in a higher income tax bracket, funds that invest in tax-exempt securities - such as municipal bond funds - might provide higher after-tax returns than taxable bond funds.

Are you buying the fund for a tax-deferred account? IRAs, 401(k)s or other tax-deferred accounts defer taxes on investment returns. Thus, such accounts might be a good place for funds that have above average portfolio turnover or pay high dividends. Tax exempt funds are not appropriate for tax-deferred accounts. Funds that are managed for tax-efficiency, such as many index funds, may be appropriate in either tax-deferred or fully taxable accounts.

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7) Be Smart About Selling Funds, Too - Your fund is down sharply. What to do? Don't give in to feelings of panic. You should review your investment goals and asset allocation targets. You may end up selling after all, but only once rationally ascertained that the fund no longer suits your needs.

When should you sell a fund? When the stock or bond market declines sharply? When the fund has poor results compared to other funds?

Either answer could get you into trouble. If you sell a fund just because the market is down, you may suffer losses - and then miss out on gains that might occur when the market rebounds. Likewise, individual funds sometimes post their biggest gains in the wake of a period of relatively poor performance.

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Here's a better answer: At the time of your annual portfolio review, sell a fund when it no longer suits your investment strategy. That might happen under these conditions:

  • You change your investment plan. For example, as you grow older you might adopt a more conservative investment approach, pruning some of your riskier funds.
  • A fund changes its strategy. A fund that alters its investment objective or approach might no longer fit your strategy

 

The fund's poor results persist. If a fund regularly trails other funds that invest in similar securities, consider replacing it.

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