Are there common threads that successful investors use to make the most of mutual fund investments? Yes, and they can be mostly distilled into five rules:
- Have a Plan and Do your Research – Define your investing goals upfront. Are you attempting to maximize returns over a shorter time horizon with a greater tolerance of risk, or achieve long-term, stable growth with reduced risk? Are you seeking income through interest or dividend payments, or is net portfolio growth your objective? Once you consider these and other factors, such as your anticipated retirement age, you can set up a plan for asset allocation and preferred fund type. This requires research on various mutual fund sponsors, the funds they offer, and the securities in which these funds invest. By performing this research diligently, it will be possible to locate funds that match your financial goals and level of risk tolerance. A trusted financial advisor can assist you in all phases of this process, from developing your plan to researching mutual funds – and other possible investments – that can help you realize that plan.
It's best to buy what you understand, so you can see through excessively rosy pictures in financial statements or a fund prospectus. Be skeptical: look at fund objectives and the degree to which they are being realized; consider historical investment returns versus similar funds offered by competitors; and scrutinize the management team if the fund is actively managed, for it is the talent and experience of this team you are betting on. If you perform proper due diligence, you are more likely to spot value in a fund — or just as importantly, lack of value.
- Minimize Fees and Expenses – Don't pay for anything that doesn't add suitable value. With mutual funds, no-load, low-expense fees are typically preferred. In general, low-expense funds outperform higher expense funds, and no-load funds outperform loaded funds.
Loads are fees that are paid directly to brokers, adding no value to a fund. If you feel obligated to pay loads to retain the advice of a broker, go back to Rule 1.
- Consider Index Funds Over Actively Managed Funds – Index funds are designed to track or replicate the performance of a given market index, such as the S&P 500 (large companies), Russell 2000 (small companies), or Dow Jones Wilshire 5000 (the total stock market). As many studies indicate that it is difficult to outperform the market consistently, index funds simply try to track a given market. Because this approach is computer-driven and does not require active portfolio management, they charge significantly lower management fees than are charged by actively managed funds. Additionally, the typical active fund manager is frequently buying and selling stocks, trying to time the market, often with poor results and excessive fees/transaction costs. Over the long haul, therefore, index funds commonly outperform actively-management funds on a total return, net-of-fees, basis.
- Take The Long View – Successful investors don't chase hot funds – they buy them before they get hot. Similarly, they don't automatically jettison falling stocks, because they understand value. Buy only when the funds are a good value based on your research, and sell when they're not, regardless of what the herd is doing. Don't let your emotions cloud your judgment (even though that's easier said than done during a sinking market).
Don't be tempted to time the funds. Chasing hot funds is a bit like selecting lottery ticket numbers based only on last week's winning numbers. There must be a reason other than past short-term performance to buy a particular fund, especially at its peak price.
You set up a plan in Step 1 based on your goals (didn't you?), so stick with that plan. Make major adjustments to your plan only if it is failing over multiple years of subpar performance.
- Don't Go on Autopilot – One mantra of Wall Street is “Plan your trade and trade your plan.” However, having a plan and sticking with it doesn't mean to ignore it once it is in place. Your plan should account for minor adjustments and constant monitoring of the funds and companies to look for value within your plan.
In summary: do your research and understand value, pay attention to your funds and the market in general, don't do things just because everyone else is doing them, and don't pay excessive fees for services that don’t yield value. As part of your research, consult with a trusted financial professional who is not just interested in making a commission on selling you shares in a fund. Make certain his or her advice is based on sound financial judgment and experience. Remember, common sense typically prevails in the market, just as it does in real life.