Mutual Fund Basics: Narrowing the Search for the Perfect Mutual Fund

February 24, 2014

 In a previous post I wrote about four advantages of using mutual funds as an investment vehicle. But if you went out and looked at mutual funds as an investment option, you may have been thoroughly discouraged.

According to Morningstar.com there were over 7,000 stock mutual funds available to investors in 2013. Among this multitude of options how can the average, amateur investor choose a fund with any more success than they can choose an individual stock? There are many different factors one can use to choose the right mutual fund.

Below are three basic factors anyone can use to get started.

Let Someone Choose for You

In the early days of my investing life I had no idea how to parse out one mutual fund from another. Fortunately, I had an employer who sponsored a retirement plan. The plan offered a range of mutual funds covering a range of asset classes. All I had to do was sign up and choose how to diversify my contributions (an entirely different problem to be covered later).

Of course, like all aspects of choosing an investment there is a level of trust required when letting someone else choose your mutual fund options. Did the employer hire a team of investment professionals to help select the mutual funds in the plan or did the CEO’s two-year-old niece choose them? Ask a few questions to make sure those choosing your investment options are knowledgeable and have your best interests at heart.

Compare Fees

Every penny spent on fees is one less penny that grows over time. Minimizing fees is an essential component to reaching goals when investing. Mutual funds can have many different types of fees.

Most mutual funds an investor purchases directly come with an array of fees ranging from sales fees, marketing fees, and management fees. It is important to understand these fees going in because once you’re in you can’t get around them.

The fee structure found in an employer sponsored plan is often much simpler to navigate than in the retail world. Typically a participant is looking at administration and asset based fees. Administration fees are usually a flat dollar amount paid each month while asset based fees are a percentage (hopefully a fraction of a percent) of the assets in a particular fund.

Would I choose a mutual fund based just on fees? Absolutely not. If an investor picks all their funds based on price it is highly likely they will end up with poor diversification and a poor investment strategy. Fees are kind of like a tie breaker between two funds that have similar strategies in the same asset class.

Risk vs. Risk Tolerance

Risk is basically the likelihood that an expected outcome will happen. It can also be an indicator of short term fluctuations in value. High risk can come with a high reward but can also come with high losses.

Risk tolerance is basically an investor’s ability to weather a specific level of uncertainity that comes with an investment. A person’s risk tolerance volatility and riskcan be comprised of time horizon, knowledge, experience investing, and financial situation.

Most mutual funds these days make it easy to quickly ascertain the general level of risk. Many fact sheets will simply show where the fund lands along a general risk spectrum. A quick glance might be all it takes to know how much, if any, contributions you might want in this type of fund.

portfolio statisticsSome fact sheets may not give as simplistic a representation of risk as the above image. Yet risk factors will usually be reported via a standard deviation and beta (β) measurement. Standard deviation measures historic volatility and beta measures risk in relation to the market as a whole. A higher standard deviation equates to higher volatility while a beta above 1.0 equates to risk above that of the market.

Risk alone is not a good indicator of whether a mutual fund is the right choice for you. While risk is an essential component in making your money grow, it’s important to hold a fund’s risk against your own risk tolerance.

Conclusions

Any of these three factors standing alone is not suitable for choosing a specific mutual fund. Each factor deserves further analysis and consideration beyond the surface level provided here. Yet, put together, these three factors form a fairly strong starting point for whittling down the options from over 7,000 mutual funds to just a few possibilities.

This post was written by Shane Linart, a Field Education Representative at Colorado PERA. If you’d like to submit a guest post, email us at  dimecontact@copera.org.