How to Pick Great Mutual Funds

Editor's note: This article appears in Kiplinger's special issue Success With Your Money. Order your copy today for more advice on how to make the most of your money at every stage of life.

When you're just starting out as an investor, all you need is an all-in-one fund, or at most a portfolio of two funds. Truth be told, that's all you need when you're older and wealthier, too. But if, along with a little extra cash, you also acquire a taste for investing, you can expand your portfolio with a more diverse group of funds.

It's easy to founder along the way, however. Take Rich Tavis. An electronic-equipment salesman in Minneapolis, Tavis didn't really have an investment plan. When he saw an attractive fund, he'd buy it, almost as if he were collecting shells on a beach. "To be honest, I don't think I had much of a strategy at all," says Tavis.

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Recently, however, Tavis decided to mend his ways. He took some time to research his funds and sold a few duds in his portfolio. He began paying more attention to fees, eliminating all the funds that charge annual expenses of more than 1.5%. "Like anything else important, I just had to make a priority of investing," says Tavis.

How much of a priority do you want investing to be? If you don't have the time or inclination to study funds on your own, index funds are for you. Rather than trying to outperform the market, index funds mirror the performance of a group of companies that represent the market as a whole or a specific sector, such as Standard Poor's 500-stock index. Index funds offer two big pluses: They're virtually guaranteed to beat the average mutual fund over time, and they require almost no monitoring.

On the other hand, index funds lack the spice of funds that are actively managed by stock pickers who think they can do better than the market. Even though the average mutual fund manager fails, plenty of stellar managers do beat the market regularly.

Picking superior funds -- whether they follow an index or are actively managed -- is only half the battle. Just as important is putting together the right mix of investments. On the following pages you'll find guidance on how to separate the great funds from the also-rans and how to assemble a portfolio that works like a well-conditioned team to help you reach your investment goals.

Mind your costs

If you pick funds on your own, stick with no-load funds. Load funds impose a sales charge that's intended to compensate a broker or other professional for selecting funds for you. That's an expense you don't need if you're going it alone.

And pay attention to a fund's annual operating expenses, which are calculated as a percentage of the assets you have invested. For example, if you invest $10,000 in a fund with an expense ratio of 1.5%, you'll pay $150 per year.

Every penny you pay in expenses is a penny that isn't working for you. In any given year, you'll find plenty of high-expense funds among the winners. But over longer periods, low-cost funds dominate the list of top performers. In general, avoid stock funds with an annual expense ratio of more than 1.5%. Limit your bond funds to those with an expense ratio of less than 1%.

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Don't chase winners

Suppose that on January 1, 2000, you had decided to invest $10,000 in each of the five best-performing funds of the preceding five years. On average, those fabulous five had earned an annualized return of 53%. But over the next five years, those same funds lost a cumulative 61% of their asset value. Your $50,000 investment would have shrunk to $19,695.

Know thy manager

In the case of an actively managed fund, it's performance that captures your attention but human beings that make the fund tick. Rather than focusing on a fund's record per se, study the performance of its manager over at least the preceding five years and preferably ten.

Obviously, you want a manager with an outstanding long-term record. But volatility—a measure of how a fund's returns bounce around over time—matters, too. And if the manager responsible for great results has departed, a fund's record may not mean much.

Be style-conscious

To compare funds, you have to know how to categorize them. That's easy to do with bond funds. You can differentiate bonds by type (corporate, municipal, government, mortgage and foreign), by credit quality and by maturity.

With stock funds, it's not quite so simple. Some funds focus on larger firms, while others concentrate on small or midsize companies. Still others invest in companies of all sizes.

Then there's a fund's approach to stock selection. Some, called value funds, invest in stocks that sell at low prices relative to company profits or other key measures -- usually because something is amiss with the company. Value managers try to pick stocks whose problems are temporary, so that when the company rights itself, its share price rises.

Growth funds, on the other hand, seek out stocks of fast-growing companies and are willing to pay the premium prices these stocks typically command. Still other funds practice a blend of value and growth investing. To get a feel for a fund's style, read its shareholder reports or examine its holdings. Or visit a Web site, such as Kiplinger.com (kiplinger.com/tools/fundfinder) or Morningstar.com, that lists a fund's style.

Diversify, diversify

Investors are a bit like fickle lovers. They'll adore certain kinds of investments for a few years, then bestow their affections on something new. Don't pile into funds that are the darlings of the hour (which recently have been those that focus on small, undervalued companies).

A better tack is to diversify among a variety of funds. Put half of your stock investments into funds that invest in large companies, divided evenly between growth- and value-oriented funds. Put one-fourth in small-company funds, divided the same way. Place the remaining one-fourth in a foreign stock fund or two.

How many funds should you own? To be adequately diversified yet easy to track, a portfolio should hold at least as many funds as a basketball team has players, but no more than a baseball team.

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Mind your costs, part II

When you invest in index funds, choose funds with no sales charges and with rock-bottom annual expenses. After all, an index fund merely tries to track the performance of an index, so there's little difference among funds other than costs.

Fidelity offers the least expensive index funds, charging just 0.1% annually for several of its most popular funds. Vanguard charges a smidgen more. For instance, Vanguard 500 Index has annual expenses of just 0.18%.

Even cheaper than those index funds are some exchange-traded funds, which are simply index funds that trade like stocks. ETFs and regular index funds each have pros and cons. For one thing, you can buy and sell an ETF through a broker any time the stock market is open, but you can buy or sell index funds only at the market's daily close.

ETFs tend to charge lower annual expenses than regular index funds, but you must pay a brokerage commission each time you buy or sell an ETF. You can buy index funds either directly through a fund company or through a broker, often without paying a commission.

If you plan to invest a large amount and keep it invested for a long time, you can probably save money with an ETF. Buying ETFs doesn't make sense if you invest a small amount every month or every quarter. In that case, it's better to stick with index funds. Expenses will be slightly higher, but you'll avoid commissions.

If ETFs interest you, iShares (www.ishares.com) offers some of the least expensive. For instance, iShares SP 500 Index (IVV) costs a mere 0.09% annually. Vanguard also offers attractive low-priced ETFs.

Know your time frame

The more time you have before you'll need your money, the more you can afford to invest in stock funds. If you're investing for retirement ten years or more in the future, for example, nearly all of your money belongs in stocks. If you're investing for your child's college education in five years, ramp down your stock allocation. And if college bills will arrive in a year or two, you don't want anything riskier than a short-term bond fund.

Steady your nerves

There's no question that stocks behave erratically over the short term. In their worst year since 1926, stocks plunged 43%; in their best year, they gained 54%. But over rolling ten-year periods (such as 1930–39, 1931–40 and so on), stocks have never lost more than an annualized 1%.

And they have always earned more than bonds and cash. On average, stocks have returned more than 10% per year since 1926, compared with 5% for bonds and just 3% for cash, according to the research firm Ibbotson Associates.

Moreover, inflation wreaks havoc with "safe" investments, such as bonds and cash. With inflation averaging 3% annually since 1926, your real, after-inflation return drops to a puny 2% for bonds and zero for cash. Stocks, however, have returned an annualized 7% after inflation.

The trouble is, "most investors have a real time horizon of 20 years or more but an emotional time horizon of about 30 seconds," says Harold Evensky, a financial planner in Coral Gables, Fla. Successful investors need the fortitude to sustain a temporary market loss of 30% or more without bailing out at the bottom. If you lived through the 2000–02 bear market, in which the SP 500 lost 47% of its value, you've already passed a real-life risk-tolerance test.

Use a sounding board

Investing decisions involve your gut as much as your brain, so find someone to help you keep your cool when the market turns sour. Warren Buffett, the greatest investor of our era, has bounced ideas off his associate, Charlie Munger, for more than 45 years.

If you don't have a Charlie Munger, you may want to hire a financial adviser. "Coaching people through some of the difficult times is one of the most important things we do," says Kirk Kinder, a fee-only financial planner in Bel Air, Md.

Have patience

Once you've picked your funds and built your portfolio, walk away. Hold on while one of your funds suffers though an inevitable rotten year or two. Don't beat yourself up when funds you don't own start to sizzle. Turn off the TV and ignore the media chatter.

Checking fund prices daily or even monthly is a waste of time; an annual review to rebalance your portfolio is enough. You've likely made the right investment decisions, so give them time to work.

Three final tips

1. Compare apples to apples. To judge the quality of a bicycle, it doesn't make much sense to compare it with a motorcycle. So it goes with mutual funds. There's no point in comparing a bond fund with a stock fund, or a fund that invests in foreign stocks with one that buys domestic companies. Assess a fund by looking at its competitors in the same category.

2. Don't time the market. Sure, pinpointing the right times to buy and sell stocks would make you wealthy in short order. But few professionals have called market turns consistently enough to produce better returns than they would have gained simply by buying and holding.

3. Past performance does matter. But in a vacuum, chasing winners is as dangerous as day trading. Not surprisingly, all five of the top-performing funds at the end of 1999 were technology sector funds. And sector funds -- which invest in just one or two industries -- belong at the edges of your portfolio, not at its heart.