Buying Mutual Funds (A few simple rules)

Investing in mutual funds is a great way to get a balanced portfolio that is professionally managed at a predictably low cost. It’s important to note that all mutual funds are not even close to equal and caveat emptor is the guiding principal. Fortunately, there are a few simple rules that you can follow to separate the good from the bad. I am focusing this blog post on open ended equity mutual funds because the rules are different for other types of mutual funds like bond funds or closed ended funds.

For equity funds you need to decide what is important to you from an investing strategy standpoint. If protection of principal is your most important criteria for an investment, don’t invest in equity mutual funds. Investing in equities means that your funds will rise and fall. If you can’t stomach a 10% decline in your principal, then stay out of these funds. If you like risk and know certain industries, then focused funds may be part of the portfolio mix. As long as you diversify along the industry lines rules 1-4 still can be followed.

The criteria that I used to select a mutual fund are as follows:

  1. Has the fund earned at least 10% on average for both the last 5 years and the last 10 years?
  2. The fund manager has not changed for the last 5 years.
  3. The expense ratio is less than 1% and the fund is a no load fund.
  4. The fund has a Morningstar ranking of 4 or 5 in all categories.
  5. The fund is not industry focused.

It should be noted that my criteria excludes several of the generally recommended options that are used to manage risk in a retirement portfolio. Specifically, I don’t like bonds or “low risk” equities. The table below will help you understand why. The American Fund at the top of the table is your typical “low risk” mutual fund. It invests in bonds and stocks based on their view of the market direction and operates on very low expenses. The remaining 3 funds in the table below all meet my criteria. It should be noted that I spent 15 minutes on the search that pulled up these funds so proving my point is not very difficult. The chart below shows the value of a $10,000 investment made in each fund in January 2007. During the 2009 -2010 market meltdown all 4 of the funds lost almost the same 30% of their value as noted by the point on the chart circled in red. However; if you look at the results after holding the funds for 10 years, the low risk fund returned 65% while the funds that followed my selection criteria returned between 250% and 300%. That’s $25k to $30k for high risk investments versus $16k for the low risk investment with the exact same jaw dropping performance during the market meltdown.

If you invest in equity mutual funds, you do need to watch them. I recommend that you look at their performance versus the market at least monthly. If they are falling well short of the S&P 500 results, then you should consider moving to another fund. Every 6 months you need to confirm the Morningstar rating and the fund manager. If there is a change, then it’s time to find another fund.

There is a lot of discussion about diversification in investments from the professionals. Diversification is the spreading of your investments across a wide range of industries and companies. If you are in individual stocks, it’s really important. In mutual funds, you don’t need to diversify because the fund is diversified already. You might want to go into a couple funds if you have a 6 figure investment just to diversify on managers, but it not essential. As you can see from the above chart, if you follow my rules, the results will be similar.

So if you are ready to invest in an equity mutual fund, you will need a screener. I have our money in Fidelity, so I use their screener. If you need to find one go to:

It works well. No investment is forever and no fund manager is perfect. There are many funds to choose from and you want to get the best return you can from your hard earned money. So do your homework and pay attention to your results.

Using this method, you can pick mutual funds that are as good if not better than the funds used by the professional managers at the large brokers. You’re assured that the investment is being made exclusively for your benefit without commissions, kickbacks or other drains on your returns. If you aren’t going to do the little bit of work necessary to protect yourself, then use a broker. However; you can add a lot to your retirement with a little effort.

1 Comment

  1. A 2% difference in yield can make a big difference over 10 years. In a $100k portfolio on a compounded basis it adds up to almost $37,000. That’s the cost of a new car or a few really nice trips. Someone is going to be making that 2%. Shouldn’t it be you?

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