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It’s been a tough couple of years for the mutual fund investors. First, they were pummeled by one of the worst bear markets since the Depression. Then, just as the market was heading back up, the mutual fund industry was racked by scandal.
After that one-two punch many investors remain nervous about where to put their money.
There’s no doubt that individual investors should be concerned. A recent study by Dalbar, an economic consulting firm, showed that from 1984 to 2002, the overall stock market rose 12.2% annually. Over the same period, individual investors’ portfolios increased 2.6% annually.
During one of the great bull markets of history, individual investors barely kept up with inflation. Sadly, these figures mean that many people will be forced to work five or ten years longer than they expected or to lower their standard of living significantly during retirement — or both.
So pay attention folks, here are five steps for choosing mutual funds and improving your returns over the long run.
Step 1: Determine what you need.
When people find out that I’m a financial planner, they invariably ask: What’s a great mutual fund to invest their money? As soon as someone asks me that question, I know they are in trouble because they’re asking the wrong question.
It’s a lot like asking what’s the best car on the market. The answer, of course, is that there are lots of good cars, but the best car will be the one that fits your needs.
It’s the same with mutual funds. Your first step in choosing the right mutual fund is to examine your asset allocation and decide what needs to be added.
Before you ask, your asset allocation is your portfolio’s mix of money market, bond, stock and real estate investments. The allocation should be based on your risk tolerance, time frame and goals.
Now, many of you might be saying, “I don’t even know what an asset allocation is, much less how to evaluate if it’s right for my stage in life.” Fair enough. That’s why I’ve included in the “Resources” box several excellent books designed for beginning investors that will give you a solid grounding in asset allocation.
Now that you’ve read these books and decided what your portfolio needs, you can begin evaluating mutual funds that invest in those types of stocks or bonds.
Step 2: Fees, Fees, Fees
I’m about to give you the best — and, ironically, most boring — advice on choosing mutual funds that you’ll ever receive.
The best indicator for how a mutual fund will perform over the long-term is the size of its annual fees — what’s called the “expense ratio.” On average, the higher a fund’s expense ratio, the lower the fund’s returns tend to be.
The average expense ratio for mutual funds is 1.6%, meaning you pay 1.6% of your money invested in the fund each year to offset the costs of running the fund.
Apparently, some funds are better at keeping their costs down than others because you can find many funds with expense ratios well below 1.0%. Vanguard Group has a number of funds that charge 0.2%.
Stick with mutual funds that charge 1.0% or less.
Step 3: Look for long-term, consistent performance.
For individual fund selection, five- and ten-year performance is most important. Look for returns equal to or above those of the fund’s benchmark index.
Don’t get seduced by mutual funds with spectacular one- or three-year returns. Over the course of a year or two, anybody can get lucky. Also, make sure that the manager responsible for the fund’s past performance is still at the helm. I’d hesitate to buy a fund with a great 10-year record if it has a new manager.
Step 4: Check out a fund’s tax efficiency and turnover.
Admittedly, tax efficiency — a fund’s ability to trade securities in ways that minimize gains taxable to shareholders — is important only if you’re holding mutual funds outside of a tax-deferred account such as a 401(k), IRA, or annuity. But for individuals investing in taxable accounts, a fund’s ability to keep dividends and capital gains to a minimum can boost your returns significantly.
A fund with high turnover tends to buy and sell assets frequently over a year’s time, rather than hold onto them. Generally such a fund will be less tax efficient than one with low turnover. Studies also have found that on average the higher a fund’s turnover, the lower its overall returns.
Step 5: Stick with the plan.
Now comes the hardest part. Once you’ve made your purchase, practice patience. Studies have shown that the main reason individual investors get such lousy returns is that they jump from one “hot” fund to the next trying to catch the fund as it rises — also known as “chasing returns.” Of course, investors always catch the fund just as it tops out and falls, causing them to lose a large chunk of their investment.
It’s a game you can’t win, so don’t play.
For everyone saving for retirement, picking the right mutual funds and sticking with them can be difference between retiring comfortably on your own terms and working for an extra five or ten year just to have enough to pay the rent in your old age.