The Six Rules of Mutual Fund Investing

Mutual funds are a great way for the average person to invest his or her money. It usually doesn’t take much to get started, you can set up automatic deposits, and you instantly participate in a vast, professionally managed investment pool giving you instant diversification and economy of scale. There are now more mutual funds than there are stocks traded on the New York Stock Exchange.

So with so many to choose from, how do you find the ones that are really worth investing in? Here are a few rules to help you find the best investment opportunities.

Rule One: Stick With No-Load Funds

A “load” is a sales fee that you pay to a broker or financial planner who sold the mutual fund to you, usually one to five percent of your investment. You might pay a front-end load when you buy or a back-end load when you sell. And what do you get for your fee? Most of the time, you get an investment that under performs a similar no-load fund, one that has no sales fee. And the only people who have ever told me that load funds are worth the fees were selling them.

Rule Two: Don’t Rely on a Top Performers List

It makes sense, right? If something’s on the “Best Performing Funds” list, three years in a row, these guys must now what they’re doing, so wouldn’t we be wise to invest with them? Yes, that’s a great achievement, but chances are they won’t stay on the “best of” list. In fact, over a ten year period, the top ten percent of funds very often fall into the bottom 50 percent. Why is that?

For a couple of reasons. For one, a successful fund attracts new investors, who give the hotshot fund manager tens of millions more dollars to invest. The manager has to do something with all that money, even invest it in companies that wouldn’t have made the grade before. Now the fund starts to under perform, literally becoming a victim of its own success.

Mutual funds also rarely stay on top of the list because markets, business and climates change. Everything, but everything goes in cycles, and a strategy that worked really well the last few years may not work well at all the next few years. A fund that says, “We invest in small, growing overlooked companies”, will shine when the business cycle favors that type of investment, and it will languish if the market wants nothing to do with them.

Rule Three: Don’t Just Pick a Fund, Build a Portfolio

Like I said, everything goes in cycles, but different things go in different cycles. Investment strategies and styles will go in and out of favor, but we don’t know which ones or when. So spread your money around so that you have some exposure to the major investment categories.

Mutual funds are categorized according to what they invest in and how they pick their investments. Some invest in large Fortune 500 companies, some invest in small growing companies, and some invest in foreign companies. Some look for companies with growing earnings and glowing prospects, and others invest in overlooked, under valued stocks. All those investment types and styles work some of the time, and they all fail some of the time. By staying invested in all those investment categories, your winners and losers play off against one another, the net effect is that your portfolio will experience overall growth over time, but without all the up-and-down swings that come with have only one investment.

Rule Four: Pick Funds with Low Expenses

A mutual fund is a business, and like a business its profits equal earnings minus expenses. Mutual funds have overhead too; it’s called an operating expense ratio (OER) and operating expenses are paid out of a fund’s investment earnings. If a fund’s investments earn ten percent over a year, and has a one percent OER, its net return is nine percent. One percent doesn’t sound like much, but it adds up over time. Imagine two funds, each returns 8% a year, and you invest $10,000 in each one at the same time. One has a 0.75% OER, the other has 1.75% OER. After ten years, the first fund is worth $24,056. The second is worth $21,740.

Now this is important: investment returns are unpredictable year over year, but fund expenses almost always stay consistent. So by picking funds with low expense ratios, you do the one thing where you know you will have control over your investment results.

Rule Five: Pick the Funds Where the Returns Exceed the Risk

All investments involve risk, we want to know if it’s a risk worth taking. To answer that question, we compare the investment returns against the risk. The return is easy to measure, basically the difference between what you bought it for and what you could sell it for. But risk can be measured too, by volatility, how far its price swings up and down. More volatility means greater risk. Divide the return by the risk to get the risk adjusted return, which tells you what a fund earned given how far out on a limb it went to earn it. A fund can under perform the averages, but still outperform on a risk-adjusted basis.

Rule Six: Do Your Homework, the Easy Way

Only a few funds are really worth your time to consider, so you want to find them quickly. For the fastest, easiest evaluation, go to www.MaxFunds.com. In the upper left corner of their home page, there’s a box called “Fund-o-matic”. Type in a fund’s name or five-letter ticker symbol, and click “go” for a one-page report.

It tells you what type of fund it is, and it’s performance ranking over different time periods on a scale of one to five (one is top 20%, five is bottom 20%). Then with a series of dashboard-like gauges, it will tell you its risk level, expense ratio, whether it leans towards large or small companies, growing or undervalued companies, how “fat” the fund is (big bloated funds tend to under perform), and finally an easily understood evaluation: green light, yellow light, red light (top third, middle third, bottom third). The green light funds are the ones worth looking into.