With more than 7,700 mutual funds on the market, it’s no surprise investors feel overwhelmed when making investment decisions.
There are plenty of factors to consider when choosing a mutual fund: past performance, manager tenure and expense ratio. But which factors are most important when making a decision?
Many investors begin the investment process by shopping for funds based on ratings or specific screening criteria. However, it’s better to first understand your own investment objectives and what types of funds will best help you meet your goals.
Here are five steps to take when evaluating which investments are the best fit for your situation.
[See: Find the Best Mutual Fund for You.]
1. Understand how you should allocate. Before buying any mutual funds, know what you are hoping to accomplish with your investments. Without a good understanding of why you are investing, it’s impossible to determine the proper way to allocate your portfolio and which funds to choose.
In most cases, the objective is to fund your retirement, but even here, the funds you use depend upon your unique situation.
The proper investment allocation depends not only on age, but other factors including health and wealth, says Charles Rotblut, vice president of the American Association of Individual Investors. “Ask how much money do you need and when do you need it? The more cash you need over a short period of time, the more conservatively you need to invest,” he says.
Rotblut also emphasizes the importance of investing to fund a long retirement. “People have to realize that their investing timespan doesn’t stop when they retire. If they retire at 60 or even 70, they could be looking at three more decades of life,” he says.
2. Determine the best assets for your investment objective. Despite the popularity of vehicles such as target-date funds, which shift the stock, bond and cash allocations at predetermined times, there is no one-size-fits-all investment strategy. Target-date funds can be an excellent investment choice in many cases, but consider your situation before you jump in.
“There are certainly people with situations that are quite different from the average person in their peer group in that same age band,” says Christine Benz, director of personal finance at Morningstar. For example, retirees traditionally put more money into bonds than stocks to mitigate risk. However, if a retiree has a spouse whose pension covers most of the couple’s living expenses, that person could allocate more to stocks because he or she can afford to take more risk, Benz says.
After determining your objective and investment strategy, determine which kinds of funds are best suited for you. Rather than being overwhelmed by the vast universe of fund choices, you can begin to focus on the kind of funds you need, such as international equity funds or domestic bond funds.
The choice between an index fund and a more actively managed fund is another factor to consider. Funds whose components track a particular index, such as the Standard & Poor’s 500 index or the Nasdaq Composite, keep trading costs minimal and offer easy exposure to a particular asset class.
Walter Deemer, author of “Deemer on Technical Analysis: Expert Insights on Timing the Market and Profiting in the Long Run,” and retired president of Deemer Technical Research, which provided market insights to financial institutions, believes investors should consider a total market index as a core portfolio position. He cites the Vanguard Total Stock Market Index Fund as an example of a core holding. “Then try to invest the remainder of your portfolio, whatever percentage that happens to be, in areas that you or your advisor think are attractive at the time. That could be an international fund, a market sector or a cap-weighted fund,” he says.
[See: How to Find the Best Financial Advisor for You .]
3. Put fund performance in context. It’s fairly common for investors to simply put their money into funds that have performed well in recent years. Benz says a deeper dive into fund performance in various stages of bull and bear cycles is warranted, and notes that five-year returns, at this point, don’t include the sharp declines of 2008. She recommends looking at the fund’s absolute return, and its return relative to funds with similar objectives. Don’t assume a good three- to five-year track record means that level of performance will continue.
“Use past performance to understand the strategy in play. The years 2008 and 2013 provide a great view of what you can expect from a fund in the future, in both absolute and relative terms,” Benz says.
4. Watch the expenses. While investors are busy focusing on performance, many overlook the expense ratios of their funds. The expense ratio includes a fund’s management, administrative, marketing and operating costs. The higher the fee, the higher the performance hurdle a fund faces to deliver a return net of fees.
Morningstar’s research has shown a direct correlation between lower expenses and better performance. Because the expense ratios appear small, with the average stock fund being under 1 percent, investors often underestimate their significance. In addition, because expense ratios are wrapped into the data in a fund’s prospectus, investors often don’t know how much they are paying for any particular fund.
[See: 7 Ways to Pay Less for Your Investments.]
5. Add to your holdings. Rotblut believes investors who work with an advisor should invest at regular intervals, particularly if they have a longer time horizon.
“Everyone asks, ‘Is this a good time to get into the market?’ I ran an analysis of somebody who got into the market in January 2000, with a basic stock-and-bond Vanguard index fund, and by the end of 2013, the investor had more than doubled his money,” Rotblut says. “So if you are going to buy and hold or at least maintain your allocation, from some standpoint, when you get in doesn’t really matter.”
Deemer says a strategy of dollar-cost averaging works best with index funds but may not be advisable with sector funds or other more specific investments. “If you were dollar-cost averaging with technology in 2000, with the Nasdaq at 5000, you were dollar-cost averaging for a long time. It’s OK if you want to dollar-cost average in an index fund, realizing that there will be times like 2008 when you’re doing this more than you should be,” he says.
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The Ultimate Guide to Buying a Mutual Fund originally appeared on usnews.com
