Today we’re going to tackle the next layer of investing: how to pick mutual funds.
To recap the Beginner’s Guide to Investing series, in part 1 we talked about selecting the best tax-advantaged retirement plans, like your IRA and 401K, which you set up before any investing happens.
Part 2 was all about asset allocation, so you have an idea of what percentage of your portfolio should be stocks, how much you want to invest in bonds, and how much to keep in cash.
I don’t personally invest in single stocks because of their high risk. Stock mutual funds minimize risk because mutual funds are diversified, meaning your money gets spread out among hundreds or even thousands of different stocks.
In fact, you’ll want to pick a few different mutual funds across different categories to spread out your investment even more.
For instance, you don’t want to pick four mutual funds that are all healthcare sector funds, or all technology funds, or all manufacturing funds. These are funds that only invest in those particular industries, or “sectors” of the economy.
You want your money to be way more spread around than that.
Dave Ramsey, for example, recommends evenly distributing your investments among four stock mutual fund categories: growth, aggressive growth, growth and income, and international stocks.
You could pick out four different mutual funds that fall into these categories (just google “growth and income stock mutual funds” and you’ll find ones like this.)
Or you could simplify a bit and do 75% total stock market index and 25% international, since a total stock market index fund has a similar composition to what Dave recommends.
But the question remains, how do you know if you’ve found a good mutual fund? I mean, there are literally thousands of choices. And no, you don’t have to comb through them all. Picking a mutual fund isn’t like finding a needle in a haystack. (Thank goodness!)
In this post, I’ll explain how to to find and evaluate good mutual funds. I’m not going to give you recommendations for the particular mutual funds you should invest in because A) there’s not one right answer, B) I would get in big legal trouble for doing that.
But honestly, there’s not one “right” or universal answer, and it’s much more valuable for you to learn how to pick a mutual fund than for me to tell you what to do.
Remember, don’t invest in something you don’t understand!
Okay, let’s dig in to the criteria for how to pick mutual funds.
The expense ratio is how much you’re going to pay to have your money invested in that fund. You don’t make a separate payment; the money comes out of your investment.
Always invest in no-load funds.
A load means you pay a percentage (like 4%) right off the top. So if you invest 15% of your income, you’re really investing 11%.
That’s a steep cost. SO much lost compound interest, it hurts to think about. Don’t do that.
No-load funds will charge anywhere from .05% to over 2.5% or more every year. And even though these are tiny numbers, they make a big difference.
If you want to nerd out with me, check out the table in this Investopedia article.
It shows that if you invest $10,000 in a fund with a .5% expense ratio with 10% annual growth, you’ll pay 9.1%, or $9,100 in expenses over 20 years. Compare that to a mutual fund with a 2% expense ratio with the same growth, and you’re shelling out 31.6%, more than $21,000.
Yes, expense ratios matter.
So why are some expensive, some cheap, and some in-between?
Primarily, this has to do with whether the fund is an index fund or an actively managed mutual fund.
An index fund is comprised of stocks (or bonds) that are selected by a computer algorithm instead of a person. In an S&P 500 Index, you have the 500 largest companies in the stock market.
Doesn’t take a human being to pick those every day.
Most of the time, though not always, index funds beat out managed funds because the human (or team) selecting stocks for a mutual fund has to pick winning stocks that will outperform an index fund enough to justify the increased expense ratio.
Which is very difficult to do, and over the long-term, most managed mutual funds cannot achieve this.
Some investors staunchly invest only in index funds because they figure why bother?
But there are a few gems out there, so it’s worth at least evaluating. If you are interested in a managed mutual fund, research WHO is managing it.
This is a real person or team with a biography and resume. When you pick a managed fund, you’re betting on a person’s ability to beat the market average, so they should have a strong track record.
Second, look at the five and ten-year performance. Dave Ramsey only invests in mutual funds with a 10 year track record that are equal to or higher than the S&P500 average of 11.6%.
You’re going for long-term here. So if the mutual fund hasn’t made big gains in the last three months but over 10 years has earned 12%, I’m much more interested in the 12% long-term gain.
Conversely, if a mutual fund has been earning 15% over the last year, yet in 10 years has only earned 3%, then I’m going to stay away!
The long-term performance outweighs the short-term.
An important vocabulary word when looking at long-term mutual fund performance is “benchmark.”
We know what a benchmark is: a standard against which something is measured, or a quantifiable goal.
The S&P 500 and total stock market indices are often used as benchmarks.
Because why invest in a mutual fund that is less diversified (you can’t get much more diversified than investing in the entire US stock market) and likely has a higher expense ratio (costs more) if the fund doesn’t perform as well?
However, you need to be aware of how this information is properly interpreted and how it can be improperly interpreted, because some advisors will use a benchmark to sell you an expensive fund.
For example, say you’re considering the Fidelity Select Software & IT Svcs Port, a leading technology sector fund that is composed of 65 biotech and pharmaceutical companies.
It has gained 36.7% in the last 12 months. Wow!
A typical total stock market index fund has returned 13% in that same time.
Here’s a quiz: what is wrong with the conclusion that it is better to invest in this technology sector fund than a total stock market index fund?
Answer: We don’t have enough information yet to draw this conclusion.
First of all, we only know the 1 year performance, not the 10 year track record.
So let’s look at that. The 10-year performance on the total stock market is 9.5%, whereas this particular tech sector fund has returned over 17%.
So your investment advisor says, “this fund has outperformed the S&P 500 benchmark so you should buy this fund.”
Well, not so fast. (Not saying your investment advisor will do this, because they should know better, but you need a solid grasp of these basics so that you know if he or she is making a true comparison).
It might be a perfectly good fund to invest in.
But the total stock market isn’t a good benchmark for this fund. If you’re looking at tech sector funds, you need to compare it to funds with a similar composition- other tech funds invested in biotech, in this example.
For tech funds, the Dow Jones Technology Index is the proper benchmark.
Basically, comparing a tech fund to the total stock market index or S&P 500 index is an apples and oranges comparison.
Bottom line: just because a fund is outperforming the overall stock market doesn’t automatically mean it’s a good investment.
Which brings us to the next factor: risk.
Higher risk correlates to higher potential gain, and higher potential loss.
If a particular mutual fund helps you achieve a portfolio composition that is appropriate for your goals, then a higher risk fund is okay, as long as it proportionally corresponds to a higher rate of return.
Likewise, more conservative mutual funds may suit your needs better in context of your overall portfolio and goals. In any case, you need to know the measures of risk and how to find mutual funds that bring good returns for their risk level, and have low expense ratios.
Those measures of risk are the alpha, beta, and r-squared value.
The beta is a number that shows volatility. A beta of 1 means the fund moves up and down with the stock market as a whole. A beta of 1.2 means the fund is 20% more volatile (think roller coaster that goes up and down) than the total stock market.
A mutual fund with a beta of more than 1 has greater potential gain in market upturns with equally greater potential loss in downturns.
A mutual fund with a beta of less than 1 has reduced potential gain in market upturns, along with lower potential loss (meaning it will do better than the total stock market) in downturns.
But again, context is everything.
The beta needs to be understood in context of its R-squared value.
The R-squared value tells us to what degree a fund’s volatility (ups and downs) is from market swings generally, and how much can be attributed to other characteristics of the fund that make it unpredictable.
The higher the R-squared value, the more reliable the beta is.
A fund with a high R-squared value (rated on a scale of 0 to 100) means the fund can be expected to perform according to its beta.
A fund with a low R-squared value means the beta isn’t very reliable, since that fund’s ups and downs could be attributed to characteristics of the fund rather than the market.
In short, the beta is only reliable if the r-squared value is high.
Market volatility is one important risk factor indicated by the beta.
However, how do you know if additional volatility risk is worth the potential additional reward?
The alpha will help you know.
The alpha is a number that tells you how well a fund manager does at beating a comparable benchmark.
An alpha of 1 means the fund outearns a comparable benchmark by 1%. An alpha of .4 indicates the fund outearns its benchmark by .4%.
As we saw with expense ratios, these small numbers make a big impact.
A negative alpha means the fund underperformed given its risk level, so you’ll want to stay away from mutual funds with a negative alpha.
To summarize, the alpha helps you decide if taking on additional risk and expense is prudent in light of higher or lower fund performance.
And finally, the Sharpe Ratio, named for the Nobel Prize-winning economist who came up with it, also calculates projected investment gain on a risk-adjusted basis.
It does this by comparing the investment to the 10-year Treasury Bond (in last week’s post, I explain why this bond is considered to be risk-free.
The logic can basically be summed up like this: if you can gain a certain return on your money with the U.S. Treasury risk-free (so long as you keep the money there for 10 years), how much more return on your investment is necessary to justify taking on additional risk?
All mutual funds have a publication called a prospectus, which contains everything there is to know about the mutual fund.
Most of the time you can find good mutual funds by google searching “best mutual funds” and reading publications by Money Magazine, U.S. News and World Report, Morningstar, Investor’s Business Daily, Kiplinger, and Wall Street Journal.
Start with some of these lists and make a comparison chart of the different mutual funds available. Compare the expense ratios, the beta and R-squared value, the alpha, and the 10-year performance.
Then you can come up with a portfolio mix of a few different categories of mutual funds that you’re happy with and will maximize your long-term gain at a prudent risk level.
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