About this time every year, the personal finance magazines will perform an annual ritual: Looking at how mutual funds have performed over the past year?and then using that information to suggest which mutual funds you should pick for the coming year. Sadly, this work is a complete waste of time.
It?s (mostly)the class, stupid
Choosing a mutual fund, all the research data show, is actually very straightforward and simple. Most of your performance depends on the asset class you select. In other words, the biggest, most important, and most significant decision you make is whether you want to put money into stocks, bonds, money market accounts, real estate, or some other class, such as international stocks.
Cost is the second factor to consider
Within a given class of investments, such as stocks, the research shows that the most significant characteristic that determines the goodness of the investment is the expense ratio charged by the mutual fund management company. For example, if one mutual fund company charges you 2 percent of your fund balance to manage your investments and another company charges you .2 of a percent, almost invariably, the mutual fund charging the lower expense ratio will do better over long periods of time.
Asset allocation for lazy people
When you understand the importance of asset allocation and investment costs, picking a mutual fund boils down to two simple issues. The first issue is how you want to apportion your money between stocks, bonds, and other investments.
Typically, you want to have the majority of your long-term investment money in stocks, some portion in bonds to reduce the volatility of your investment portfolio, and some portion of your money?perhaps your rainy day fund?in something like a money market account.
The second issue you need to focus on in selecting a mutual fund is the expense ratio. Fortunately, the Internet and Money?s hyperlinks let you rather easily get to mutual fund prospectuses, and these materials provide expense ratio information. This is where you want to start?and probably finish?your mutual fund investing. You almost can?t win if you choose a mutual fund with a very high expense ratio. You almost can?t lose if you choose a mutual fund with a very low expense ratio.
Why not try to beat the market?
Let me also briefly address the issue of finding a mutual fund manager who generates above average returns. Clearly, some mutual fund managers, over time, have produced extraordinary returns?returns so high that they more than offset even large expense ratios. The point you need to realize, however, is that if you do choose to look for a star mutual fund performer, what you need to do right now is identify somebody who is going to be a star over the next two or three decades, not someone who has been a star over the past two or three decades. Long-term investing means you are looking out several decades into the future?even if you are retired.
Note, too, that who performed well last year is no indication of who is going to perform this year. Repeatedly, studies have shown that last year?s or last quarter?s hot performer is not this year?s or this quarter?s hot performer.
Putting my money where my mouth is
Here?s my personal investment strategy. I am a firm believer in index funds. From the mid 1908s and through the late 1990s, I invested almost my entire portfolio (perhaps 95 percent or more) in the widest available stock index fund available to me. In the late 1990s, after the stock market became obviously over-valued (I said this in print in books like the Million Kit (Random House, 1999), I began using balanced index funds (which index both stocks and bonds).