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Brain-Dead Mutual Fund Selection
By: Stephen Nelson
About this time every year, the personal finance magazines will perform an
annual ritual: Looking at how mutual funds have performed over the past year—and
then using that information to suggest which mutual funds you should pick for
the coming year.
Sadly, this work is a complete waste of time.
It’s the class that matters most
Choosing a mutual fund, all the research data show, is actually very
straightforward and simple. Most of your performance depends on the asset class
you select. In other words, the biggest, most important, and most significant
decision you make is whether you want to put money into stocks, bonds, money
market accounts, real estate, or some other class, such as international stocks.
Cost is the second factor to consider
Within a given class of investments, such as stocks, the research shows that the
most significant characteristic that determines the goodness of the investment
is the expense ratio charged by the mutual fund management company. For example,
if one mutual fund company charges you 2 percent of your fund balance to manage
your investments and another company charges you .2 of a percent, almost
invariably, the mutual fund charging the lower expense ratio will do better over
long periods of time.
Asset allocation for lazy people
When you understand the importance of asset allocation and investment costs,
picking a mutual fund boils down to two simple issues. The first issue is how
you want to apportion your money between stocks, bonds, and other investments.
Typically, you want to have the majority of your long-term investment money in
stocks, some portion in bonds to reduce the volatility of your investment
portfolio, and some portion of your money—perhaps your rainy day fund—in
something like a money market account.
The second issue you need to focus on in selecting a mutual fund is the expense
ratio. Fortunately, the Internet and Money’s hyperlinks let you rather easily
get to mutual fund prospectuses, and these materials provide expense ratio
information. This is where you want to start—and probably finish—your mutual
fund investing. You almost can’t win if you choose a mutual fund with a very
high expense ratio. You almost can’t lose if you choose a mutual fund with a
very low expense ratio.
Why not try to beat the market?
Let me also briefly address the issue of finding a mutual fund manager who
generates above average returns. Clearly, some mutual fund managers, over time,
have produced extraordinary returns—returns so high that they more than offset
even large expense ratios. The point you need to realize, however, is that if
you do choose to look for a star mutual fund performer, what you need to do
right now is identify somebody who is going to be a star over the next two or
three decades, not someone who has been a star over the past two or three
decades. Long-term investing means you are looking out several decades into the
future—even if you are retired.
Note, too, that who performed well last year is no indication of who is going to
perform this year. Repeatedly, studies have shown that last year’s or last
quarter’s hot performer is not this year’s or this quarter’s hot performer.
Putting my money where my mouth is
Here’s my personal investment strategy. I am a firm believer in index funds.
Through the late 1990s, I invested almost my entire portfolio (perhaps 95
percent or more) in the widest available stock index fund available to me. In
the late 1990s, after the stock market became obviously over-valued (I said this
in print in books like the Millionaire Kit (Random House, 1999), I began using
balanced index funds (which index both stocks and bonds).
About the Author:
Seattle tax CPA & author Stephen L. Nelson wrote Quicken for Dummies and more
than 100 other books as well. Nelson holds an MBA in Finance and an MS in
taxation. His web site is http://www.stephenlnelson.com
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