By nature, I hate risk. Sure, I know on occasion circumstances demand or persuade me to accept more than I desire. In those instances, I’m way out of my comfort zone. Yes, it can be exciting, but I would much prefer life grant me slow, boring, predictable moments that are within the scope of my abilities and emotions to handle. That’s my personality.
It’s also why many people hate investing, especially when it comes to learning how to choose a mutual fund.
“Mutual funds are boring investments,” they say. “I want the sexy action of the newest individual stock.”
“Mutual funds are slow,” they say. “I want investing performance measured in days or weeks, not years.”
“Mutual funds are predictable,” they say. “They mostly track the performance of the general market.”
To “they” I say, “OK.” If that is your risk tolerance, more power to you. But I won’t be recommending a seat on that roller-coaster ride for investors, especially beginners. Too much risk, too little diversity for someone just starting out.
In part three of this series, I introduced the investing term “diversification.” Diversification means to spread our money around. When we diversify, we don’t put all of our hard earned dollars into one specific stock. By placing money in different investments, we protect the whole, should one of our investments falter. It’s the #1 reason mutual funds are the best place for the investors – because even by only owning one fund, you get instant diversification. Here’s how.
What Is a Mutual Fund?
A mutual fund is a collection of different stocks all rolled up into one instrument. By purchasing the fund, investors big and small pool their collective money and get exposure to all the stocks in the fund. Some funds are smaller with 30-50 stocks while others have hundreds, even thousands.
For example, Vanguard’s flagship fund is the Vanguard 500 Index Fund. It’s been around since 1976 and is designed to mirror the performance of the S&P 500. Because it wants to move in lock step with the S&P 500, it must proportionally invest in the 500 companies that are in the index. These companies represent the largest U.S. companies, spanning many different industries.
A look at the top ten holdings of this fund would reveal some very familiar names (listed in order from #1-10): Apple, Exxon Mobil, Microsoft, General Electric, Chevron, Johnson & Johnson, Google, IBM, Procter & Gamble, and JPMorgan Chase. These are the titans, the big boys of industry and they represent around 18% of this fund’s $139.6 billion total in net assets. The other 490 companies make up the remaining 82% of the fund assets.
So if Google begins to outpace Apple in the smartphone war, their stock will most likely rise while Apple’s stock will fall. This would be a problem if an investor were ONLY invested in Apple. Their portfolio would suffer, perhaps quickly. But by investing in the fund, Google’s rise counteracts Apple’s fall and the result is a wash for the investor. There would probably be little change in the value of the fund based on this basic scenario alone.
That’s how mutual funds help reduce risk. If one stock fails the whole fund doesn’t fail.
How to Choose a Mutual Fund
You may feel the urge to get started with this process quickly but there is no need to rush into a purchase. There are a few things to consider before you even start looking at funds. If you do these three things, your investing life will have a much greater chance of success.
1. Identify your risk tolerance. Every fund has a risk scale from low to high. Vanguard lists their 500 Index Fund as a 4 on a 1-5 risk scale, with 5 being highest risk. It’s riskier because this fund has full exposure to the U.S. stock market. In other words, it is an all-stock fund that will go up and down as the market goes up and down.
So the question you need to answer is, “How much risk am I willing or able to take based on my life situation, investing knowledge, and my emotional capacity to weather market fluctuations?” There is no textbook answer – it’s a personal decision.
2. Identify investing goals. Mutual funds have different goals. Some produce income for investors. Others are focused on growth. Some help parents save money for college while others are focused on retirement.
So the question to answer here is, “What am I trying to accomplish with my investing dollars? What do I need?”
3. Determine your asset allocation. In other words, develop a plan to spread your money around to get maximum exposure to as many stocks as possible.
The Vanguard 500 invests in the 500 largest companies in the U.S. It’s a great place to get the large company capitalization exposure one needs in a portfolio. (Capitalization refers to a company’s size.) Some companies aren’t that big and are called mid-cap or small-cap. They are growing, sometimes aggressively. An investor needs some of these smaller, aggressively growing companies in their portfolio as well.
Still other companies aren’t in the U.S. (Yes, they have investing markets in Europe, South America, Japan and other places.) These companies would be found in an international stock mutual fund. An investor will eventually want exposure here also because sometimes the world markets perform better than the U.S. market.
Given these four classes – large cap, mid-cap, small cap and international – an investor’s asset allocation could look like this:
25% invested in large cap mutual funds
25% invested in mid-cap mutual funds
25% invested in small cap mutual funds
25% invested in international mutual funds
That’s just an example. Figuring out the percentages, or whether or not to include some fixed income (or bond) funds in your portfolio will be your call.
Other Factors When Choosing a Mutual Fund
Mutual fund companies give details about their funds that require our attention. Here are some things to look for when doing research:
1. Evaluate fees and charges. It costs money to hire the personnel to manage these funds and that expense is passed on to the investor. Look for expense ratios at less than 1%. The higher the expenses, the more those expenses will eat into returns. (As a point of reference, the Vanguard 500’s expense ratio is .17%. That’s very low. It’s low because they don’t have to do much to manage the fund. It’s designed to track the S&P index.).
Some funds even charge commissions on trades. In the mutual fund world, these are known as “loads.” Look for that terminology and avoid funds where the commissions are excessive. (Perhaps avoid loaded funds altogether.)
2. Look at turnover. Turnover rate refers to the percentage of a fund’s holdings that have been replaced (turned over) with others during the course of the year. In general, lower turnover is best.
3. Review past performance. All funds show how they have performed over various time intervals. Look for funds that have been in existence at least five years, the longer the better.
Evaluating past performance is important. However, past performance is not a guarantee (or a predictor) of future results. We cannot say a fund will continue to perform like it has because we do not know how future world and economic events may affect that fund. It’s an indicator only.
But it is the best indicator we have. Funds like the Vanguard 500 that show a 10.75% average annual return since its inception in 1976 are a good bet to continue that performance. As of 2013, that’s a 37-year fund history of investing through good times and bad with a very decent return.
4. Be aware of minimum investment requirements. Some funds allow an investor to begin with as little as $50. Others, like the Vanguard 500 require more. In this case $3,000 is the required initial investment.
Learn as much as possible about the funds. Know exactly what you are getting into and why. Remember, if you can’t explain it to someone else, then you probably should not be investing in it.
Final Steps When Choosing a Mutual Fund
Setting up a trading account is the final step in the process and it’s pretty simple. This can be done through a discount brokerage firm like Scottrade or Etrade. Or you can choose to go through other investing companies like Vanguard, Fidelity or Charles Schwab. Again, it’s a personal preference here – research them all.
There will be paperwork (either online or mailed) that needs to be filled out and, of course, money deposited in the account (by mail or wire transfer from your bank). Wait until you receive a positive account confirmation status from the company before you send any money, unless they say otherwise. Once the money in your account has been cleared for trading, you will be free to purchase the fund of your choice.
When it’s time to purchase your shares of the fund, look at the fund’s NAV or net asset value. The NAV is the mutual funds price per share. It’s calculated once each day based on the closing prices of all the stocks in the fund. Base your trade on how many shares your cash will buy.
If you know how to choose a mutual fund you realize they are the low-maintenance, diversified, sleep-well-at-night investing machines that serve as the cornerstone of an investor’s portfolio. For my money, it’s where everyone should start on the investing journey.
Questions: What questions do you have on how to choose a mutual fund? What other items should an investor look for in a mutual fund? Are you satisfied with the mutual funds you have chosen?
(Disclosure: I am not compensated for mentioning any of the investment companies or brokerage firms in this article. I do have assets at Scottrade, Vanguard and Charles Schwab.)
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