Question of the week: I've just come into a small inheritance and I want to sock it away for the future. Everyone tells me that I should be looking into stock mutual funds. If you were to believe all the mutual fund advertising, you'd think that every fund is a winner. How do I really know which fund is any good? --Joel
Dear Joel,
For people who don't have the time and expertise to research and track individual stocks--which includes most of us--mutual funds are one of the best possible ways to invest. And a lot of other investors agree--the Investment Company Institute, the trade group for the mutual fund industry, says that Americans have nearly $7 trillion stashed away in mutual funds.
But there are thousands of fund choices, so it's very important to sort out the weak from the chaff. We recently asked the Armchair Millionaire community for its advice on what to look for when shopping for a fund. They offered us this battle-tested wisdom:
Check out the management. "I look for long-term management. I want my fund managers to have been in their jobs for a long time--at least seven years." --Cole
Consider fees. "I look at the fees first. Just because a fund charges higher fees doesn't mean that it is well managed. If a fund has above-average fees, I skip it." --ACF
Compare returns to a benchmark. "The past performance of a fund alone is meaningless. You have to compare it to how the market overall has done. I always compare large cap funds to the S&P 500 index and small cap funds to the Russell 2000." --James49
Watch the tax impact. "I want my money managed for the least taxable exposure. I expect my fund managers to be able to manage the fund for maximum tax efficiency." --Presto
It's also important to know what not to do when choosing a fund. Use my checklist to avoid the most common mutual fund mistakes.
The Armchair Millionaire's Checklist of Mutual Fund No-Nos
Don't pay a load. Loads, or sales fees, come straight out of your investment. There's no evidence that load funds perform any better than no-load funds, so keep your money and stick with the no-loads.
Don't overlap. Funds are themselves a diversified investment, but don't think that owning a lot of funds means that you'll be even more diversified. Instead, you may end up with many funds that own the same stocks. You should be able to achieve adequate diversification with as few as two or three funds that target different areas of the overall stock market.
Don't chase performance. Last year's hot fund can be this year's laggard. Making your fund choices based on recent performance has historically been a losing proposition. Look for long term histories through a variety of market conditions such as bull markets, bear markets, recessions and periods of economic growth.
Don't trade in and out of funds. Trying to time your investment and switching frequently between funds is pointless. You invest in funds to leave the trading up to a professional, so leave your money in your funds long enough for the portfolio managers to do their jobs.
THE BOTTOM LINE: All mutual funds are not created equal. When you choose a mutual fund, you're really choosing a person or a team to manage your money. Use common sense and make sure to get objective advice before you make a purchase.
