There is an old saying in the investment community that the average investor spends more time researching what toaster to buy than what mutual fund to invest in. With this in mind, we thought that it would be a good idea to identify some issues that should affect your investment decision regarding a specific mutual fund. Please keep in mind that by no means is this a complete list of considerations, but just some that an investor should be aware of.
Whether investing in mutual funds or individual securities, an investor must first identify their investment objectives, including the intended time horizon until reaching those objectives as well as the risk and volatility they are willing to assume along the way. Furthermore, an investor must decide whether they are going to require help when selecting specific investments. However, please keep in mind that even if you are going to require advice, that does not eliminate the responsibility of the investor in determining how their advisor is compensated and what charges, if any, will be levied by the mutual fund. An additional piece of investigatory work that an investor must do prior to putting their hard earned money to work is to review the prior returns of the specific mutual fund, keeping in mind the risk that the fund has taken in order to achieve those returns and then applying an appropriate benchmark to determine the relative returns; always keeping in mind that historical investment returns are not indicative of future investment results. Finally, prior to investing an individual should have enough cash on the sidelines for emergencies such as home repairs, short-term unemployment or health issues.
The answers to all of the questions noted above can be found on the internet either at the website of the family in which the mutual fund you are considering is a member, on a financial website such as Yahoo! Finance or at Morningstar.com. However, let’s take a couple of paragraphs and determine that you will be looking for after arriving at one of these or a similar site.
The first consideration we noted was to make certain that the investment objective of the mutual fund matched that of the investor’s. Prior to investing, it is imperative to determine the percentage of the fund that can, by prospectus, be invested in stocks, bonds, cash or other instruments. Generally speaking, the higher the percentage in stocks, the more volatile the fund. An investor who invests into a fund with more than 75% of its assets in the stock market is implying that he has a time horizon or ten or more years and is willing to accept the volatility along the way. An investor who chooses a fund with 50%-75% in the stock market is implying that he has a time horizon or five to ten years and is somewhat concerned with volatility and preservation of capital. Finally, an investor who chooses a fund with less than 50% is implying that preservation of the majority of their capital is a primary concern and that capital appreciation is secondary.
Volatility of a fund can be measured in several different ways, with the two most common being beta and standard deviation, both of which can be found on the internet or in the prospectus of the mutual fund. Simply put, the beta of the fund tells an investor how sensitive a fund is, in response to the movement of the stock market. The stock market always has a beta of 1.00 so if the beta of the mutual fund you are researching has a beta of 1.25 it means that the fund is 25% more volatile than the overall stock market. Therefore, it is safe to assume that if the stock market goes up 10%, you can expect 25% more gains from your fund. However, the opposite also holds true. Should the stock market fall 10%, one could expect a decline 25% greater than that. Standard deviation also measures the volatility of the fund in that it helps determine how often the fund has wild swings. According to Morningstar, a leading researcher of mutual funds, “approximately 68% of the time, the total returns of any given fund are expected to differ from its mean total return by more than plus or minus the standard deviation figure.” In plain English, referring to standard deviation, the higher the number, the rockier the ride will be.
Regarding the cost of entering or exiting a fund, an investor must always remember that nobody works for free. So there is a cost. Ask your investment advisor the explicit or internal costs of investing in a particular fund. If he or she balks at your question, ask specifically how much the advisor is compensated as a result of a potential investment. If they are unwilling to answer, look for another advisor.
Finally, when reviewing past returns, as mentioned above, it pays to keep in mind the risk the fund has historically assumed to achieve their returns. It is important to look at the absolute total returns, but more important to look at the returns relative to an appropriate benchmark such as the S&P 500 or Morgan-Stanley Composite Index for the European, Australian and Far-East (MSCI/EAFE) markets. This number will tell you how the fund fared against its peers.
In conclusion, if you take the time to know what you are getting involved in prior to making an investment than you will be much more capable of making intelligent, rational decisions on perhaps when to make changes. This will ultimately help you reach your goals. Good luck!