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, stupid
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 Million 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
