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.
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.
For these reasons, picking a mutual fund should really revolve around two 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 so
me- thing 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.
Let’s 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.
Here’s our investment strategy. We’re firm believers in stock index funds. For more than a decade now, we have invested our portfolios (perhaps 95 percent or more) in the widest-available stock index fund. When we started out using index funds, the only
index that was available was a Standard and Poors 500 index fund. But when the to- tal stock market index fund based on the Wilshire 5000 became available, we used that.
Current (at least at the time of this writing) high stock market valuations, particularly for technology companies, make us think it’s wise for even young investors to have some portion of their portfolio in bonds. Including bonds in your portfolio will dampen the
volatility of your investments and may make it easier for you not to worry about day- to-day or week-to-week fluctuations.
CPA Stephen L. Nelson is the author of do it yourself kits for href="http://www.fasteasyincorporationkits.com/TexasCorporationKit.htm">Incorporating in Texas, Texas S corporation and href="http://www.llcsexplained.com/doityourself_Texas.htm">Texas limited liability company.