You shouldn’t have to worry about picking mutual funds if you don’t want to.
That is, if you have zero interest in immersing yourself in fund performance data and anlayst research, you will do best with a simple investing strategy: invest in an index fund that tracks the entire stock market.
Why? Because in the long run, actively-managed mutual funds rarely outperform the market.
CHOOSE INDEX FUNDS FOR SELF-GUIDED INVESTMENT
If you are investing on your own for more than 10 years (in an individual retirement account, for example), I recommend investing in a stock market index fund and a bond market index fund with low expense ratios. (Last week, I explained mutual funds costs and their importance to your investment returns here.)
If you plan to invest small amounts over time—monthly, for example—invest directly with the fund company using their automatic investment plan. Find examples from Vanguard, TIAA-CREF, or T. Rowe Price.
If you are investing a lump sum, you may consider an exchange traded fund (ETF) as an alternative.
Later this week I’ll provide some examples of each.
WHEN YOU MUST PICK A MUTUAL FUND…
Sometimes, you won’t be able to choose an index fund in which to invest. For example, your 401(k) or other retirement plan at work will likely ask you to choose from a number of mutual funds. If an index fund in not among them, how do you know which fund is best for you?
There are two areas to consider:
- The fund’s suitability to your investing goals.
- The fund’s management style.
THE RIGHT FUND FOR YOUR GOALS
If you’re under 35 and investing for retirement, you’ll want to seek out funds that have the following characteristics
- Invest mostly in stocks (domestic or foreign)
- Use terms like “aggressive”, “high risk/high return”, or “capital appreciation”
For investing periods of less than 30 years but more than 10 years, look for funds with more moderate risk/reward profiles. These funds will:
- Invest in a mix of bonds and (mostly domestic) stocks
- Use terms like “balanced” or “moderate risk”
Investing for short-term goals requires a lower risk fund. Look for funds that:
- Invest mostly in bonds
- Use terms like “conservative” and “capital preservation”
A note about target-date funds
Target date funds are increasingly popular in 401(k) plans and other plans that provide you, the participant, with limited investment choices.
Target date funds are designed to provide the ideal risk level for a given withdrawal year (most commonly, the year in which you plan to retire). These funds are popular because they make choosing the fund easy and eliminate the need to move money into more conservative funds as you get holder.
To find the right target date fund for you, simply subtract your current age from 65 (or your desired retirement age). Add that number to the current year, and choose the nearest target date fund. Example: I’m 30. 65 – 30 = 35. 2011 + 35 = 2046. I’d pick a 2045 target date fund.
For most investors, target date funds are fine and allow you to “set it and forget it”. Some are better than others. So if you want simplicity, go with a target date fund. If you’re willing to do a bit more work to make sure you’re putting your money in the best place possible, compare facts about the target date fund to other available funds before picking your fund.
DECIPHERING A FUND’S MANAGEMENT STYLE
Found a fund candidate based on your investing objective? Next, review data on the fund on a site like Moringinstar or directly in the fund’s prospectus. Make sure it has:
- NO load, a sales charge that you should never pay
- A low expense ratio (under 1%)
- Low turnover (less than 50%)
To better understand a fund’s load and expense ratio, read last week’s post.
Turnover is the length of time a mutual fund holds stocks. The goal is to find mutual funds that hang onto stocks for a long time, resulting in a lower turnover. This results in lower trading expenses and capital gains taxes.
MUTUAL FUND RETURNS
Obviously, you’re not going to invest in a mutual fund without taking a peek at its historical returns. When you do, remember two things:
- Consistency is more important than a single blockbuster year.
- Past performance is no guarantee of future results.
Look for a fund that has done as well, better, or at least almost as well as the overall market year after year. If that fund meets your investing goals and has low expenses, you’ve found a winner.
Check back later this week for a few specific fund suggestions to get you started.