How Should You Pick a Mutual Fund? Not Like This

Common mistakes include listening to friends, chasing performance, ignoring fees and being too cool for bonds.
Investing, Investing Strategy, Investments
wrong ways to pick a mutual fund

Congratulations, you’ve decided to invest in a mutual fund. Now comes the hard part — which one?

More than 8,000 mutual funds are on offer, according to the Investment Company Institute, an industry group, and they range from “domestic or world equity funds (actively managed or indexed), to domestic or world bond funds, to alternative funds, to money market funds, to diversified funds such as balanced or hybrid funds, including target date funds.”

Yikes. Confronted by the number of options, the first request many first-time fund investors make is, “Tell me which one is the best,” says Laura Scharr-Bykowsky, a certified financial planner and principal at Ascend Financial Planning in Columbia, South Carolina.

Buying into a mutual fund without understanding how it fits into your total financial future is a common newbie mistake. “It’s not what the best fund is, but what’s the best fund for your risk tolerance, your goals and your retirement plan,” Scharr-Bykowsky says.

Here are a few other mistakes investors make when deciding how to pick a mutual fund:

Chasing hot-performing funds

A client may see that an emerging markets fund had 25% returns last year and think, “Emerging markets look like the way to go,” Scharr-Bykowsky says, only to discover a steadfast rule of investing the hard way: What goes up also comes down.

“We tend to be very nearsighted when it comes to the markets and try to market time — jump in and jump out of different funds,” she says. Chasing performance often results in the opposite effect: buying a fund when returns are high and selling when returns sag. The chase can be a costly game of whack-a-mole, striking just as hot performance cools.

Mutual fund marketing materials carry the obligatory note that “past performance is no indication of future results,” but that’s more than government-required legalese. It’s an important fact, says James Kinney,  principal at Financial Pathway Advisors in Bridgewater, New Jersey.

Study after study shows that a fund’s recent track record is a poor way to gauge future returns, he says, “but what I often see are people who look at past performance and nothing else.”

» Invest in mutual funds the right way: We cover what you need to know

Following a suggestion from family or friends

Right, so if you can’t can’t rely on a fund’s performance to make your choice, whom can you trust? Many new investors lean on those closest to them.

“I hear things like, ‘My buddy who sits next me said it did well.’ Or, ‘My dad told me about a Vanguard fund I should buy,’” Scharr-Bykowsky says.

Even in the digital age, word of mouth carries a lot of weight, especially when it comes to facing big financial questions. But unless your friend, colleague or family member is on the same financial footing as you, there’s a high risk that fund you chose on hearsay is a bad match, experts warn.

Picking the funds with highest star ratings

Morningstar, an investment research firm, publishes an influential list of mutual funds ranked from one to five stars. So, just pick the fund whose star rating is the highest, right?

Star ratings are a good way to begin researching the right fund but are heavily influenced by recent performance

“You need to be really careful of those,” Kinney warns. While star ratings are a good way to begin researching the right fund, “they are still heavily influenced by recent performance,” he says. Morningstar itself notes that its star system “is intended for use as the first step in the fund evaluation process. A high rating alone is not a sufficient basis for investment decisions.”

Funds with a less than stellar ranking right now “could be perfectly good funds that have had poor performance for completely valid reasons,” Kinney adds, and still could carry long-term value for your portfolio mix. “They may be good funds that have a strategy that may be out of favor today, but these things are very cyclical in nature.”

Thinking bonds are too boring

New investors get into mutual funds for the long-term growth, which is why equity mutual funds are one of the most popular kinds of mutual funds. Equity funds track the stock growth of a large swath of companies by index, industry or country.

“I see a lot of younger investors who want to invest primarily in tech, because that’s cool and sexy and they think it’s bound to go up,” Scharr-Bykowsky says. But investors in the late 1990s thought the same thing before the dot-com bubble burst.

Less risky are bond funds, whose underlying asset is government or company debt. The investor lends money for a set period of time, with the promise of repayment of the original investment plus interest. While stocks offer greater potential for long-term growth, bonds can balance out the risk in your portfolio by offering a steady stream of income.

“Bonds are boring as heck, but they are great shock absorbers,” Scharr-Bykowsky says. “A lot of people wished they had more bonds in their portfolio in 2008” when markets crashed during the Great Recession.

Ignoring the fees

Another common misstep is choosing a mutual fund without understanding the long-term impact of fees — also known as the expense ratio — on total returns. Fees vary depending on whether you choose a passive fund — one that tries to mirror the growth of an index like the Standard & Poor’s 500 index of large companies, for example — or an actively managed fund, which aims for market-beating performance and is costlier.

The fees as a percentage of total investments may seem low compared to the double-digit interest rates you see on a credit card statement, but “fees can really erode your total returns over time,” Scharr-Bykowsky says.

Say you had $100,000 in a fund, and that fund delivered 7% returns annually. After 30 years, you’d be very happy. But the fund’s expense ratio would affect just how happy you’d be.

Expense ratio0.25%0.5%1%
Total cost of expenses$51,857$99,788$186,786
Portfolio value after 30 years$709,368$661,437$574,349

Passive funds charge lower fees and tend to have better returns, making them the best choice for many investors. If you’re interested in an actively managed fund, Kinney recommends looking for funds that have the lowest fees and the highest buy-in from the fund manager. “It’s important that they have skin in the game,” he says.

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