There’s 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.
In hopes of preventing you from getting burned, here are some things you need to consider when it comes to investing in a specific mutual fund.
As an investor, first identify your objectives. This includes an intended time horizon until reaching those objectives, along with the risk and volatility you’re willing to assume along the way. Also, you need decide if you’re going require help when selecting specific investments.
However, if you are going to require advice, that doesn’t eliminate the responsibility of the investor to determine how your advisor is compensated and what charges, if any, will be levied by the mutual fund.
You also must review the prior returns of the specific mutual fund, keeping in mind the risks the fund has taken in order to achieve those returns. The next step is to apply 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 you should have enough cash on the sidelines for emergencies — home repairs, short-term unemployment and/or health issues.
Help for all these steps can be found on the internet, either at the website of the mutual fund family or a financial website such as Yahoo! Finance or Morningstar.com. Here’s what to look for after arriving at one of these sites.
Make sure the objective of the mutual fund match your objectives. Prior to investing, it’s imperative to determine what percentage of the fund 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 of 10+ years and is willing to accept 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 of 5-10 years and is somewhat concerned with volatility and preservation of capital.
Finally, an investor who chooses a fund with less than 50% is implying 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. The two most common are beta and standard deviation. Both of these 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. Therefore, 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. This means (in general) if the stock market goes up 10%, you can expect 25% more gains from your fund. However, the opposite is also 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, the higher the standard deviation number, the rockier the ride will be.
Regarding the cost of entering or exiting a fund, an investor must always remember nobody works for free. There is always a cost. Ask your investment advisor the explicit or internal costs of investing in a particular fund. If he or she balks at that 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, keep in mind the risk the fund has historically assumed to achieve those returns. It’s 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.
If you take time to know what you’re getting involved with prior to investing you will be much more capable of making intelligent, rational decisions. The same goes for when it’s time to make changes to your portfolio.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, Please call (518) 279-1044.
