How to Choose the Right Mutual Funds

Most people with a 401k have a group of mutual funds which to choose from, for your own account than you have thousands to choose from. Choosing the right mutual funds is the important part.

Most people with a 401k have a group of mutual funds which to choose from, for your own account than you have thousands to choose from. Choosing the right mutual funds is the important part. Once you learn the basics of mutual funds, you can then choose the right mutual fund.

Risk tolerance

Risk tolerance is defined as the degree of uncertainty that an investor can handle in regard to negative changes in their portfolio of stocks, bonds and mutual funds.

What is your tolerance for risk, usually the younger you are the more risk you can take. That’s because you have more years to make up for losses. And the closer you get to retirement and the closer you get to the time you will need your money, the more safe funds you need to have.

Diversification

Diversification is basically not putting all of your eggs in one basket. Diversification also helps to reduce the risk of your stock or mutual fund portfolio going down too much in a down market.

When you don’t have much money to invest in your mutual funds, it can be a little harder to diversify, but you still can and should.

If you have a small amount of money and don’t really have the time to diversify yourself, you can buy what’s called an Asset Allocation fund. These mutual funds are already diversified.

There are also what’s called Lifestyle funds, they will have names in them like 2010, 2020, 2030 etc. These mutual funds are designed for someone who will retire and need their money by the year in the mutual funds name. If you are going to retire in 2030, then you might consider owning a lifestyle mutual fund like the Fidelity 2030.

Many times when one sector or part of the stock market goes down, another part or sector will go up, and if you own some mutual funds in both of those sectors, that is what diversifying will do.

Usually when stock market goes down bond mutual funds will go up and visa versa. So owning a bond fund along with a stock (equity) fund, you will be diversified in that way.

Diversifying by your age, if you’re in your 20s or early 30s, you might just have all stock funds in your portfolio and no bond funds. As you move into your 40s you start to have the more safer bond funds in your portfolio. Maybe by 50 years old, you might have something like 35% bond funds and 65% stock funds.

Finding the Best Mutual Funds

You do what’s called screening. You are screening for the best funds that meet your criteria in a certain sector of the stock or bond market.

I usually look and screen for only no-load funds.

There are several good fund screeners on the internet, and you can use all of them to get your results. I am most familiar with this one:

Morningstar mutual fund selection tool

Manager tenure can be very important to look at. If the managers change all the time, then any of the past results of that fund can never be relied on. If for example a fund has done great in the 5 year or 10 years and then that manager leave, you cannot use the historical returns as any kind of guideline. I like a fund to have a consistent manager running the certain fund.

Stars: I would also only look at 4 or 5 star funds of the Morningstar rating system for both risk and return.

Risk: The higher the risk the more volatile the mutual fund will be, the more it could go up in an upward moving market and the further if can go down in a down market.

Beta is a term that defines volatility, the higher the beta the more volatile the fund is. A mutual fund with a beta of 1 should move with the overall stock market. A fund that is more volatile then the overall stock market would have a Beta over 1.

Expense ratio: Every fund has this, like all fees the lower the better. Small cap funds usually have a higher expense ratio than large cap. Index funds have very low expense ratios. When comparing expense ratios, compare the fund to other mutual funds in its own sector.

You can make most of these “category averages” until you get used to these and know exactly what you want in a fund.

Then you click on Score. From there you can change how important you think each of these criteria are on a scale of 1 to 10. You can also customize your criteria.

Comparing Mutual Funds

If you are looking to choose the best funds out of a list of funds such as in your 401k options, I like to use this compare funds tool at Morningstar. It is free, but you will have to register to use it.

Morningstar mutual fund comparison tool

Enter in the symbols of the funds you are choosing from in the upper box.

When you enter in your list of mutual funds, you are trying to find the best one out of your choices. It is important to compare apples to apples; you shouldn’t compare bond mutual funds with stock mutual funds for example.

You can sort this list any way you want to, for example sort by the best YTD (year-to-date) returns, or 5-year returns or lowest expense ratios etc.

When you have the comparison results on your screen, you can look at each one of them and see all the data for them by clicking on the mutual funds name.

Sam Montana © 03 December 2008

Resources:

Morningstar

MSN Money

Lipper

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Posted on Dec 4, 2008