Guide to Mutual Funds

Why invest?

Compounding of returns is your friend. With it, time is on your side. Start investing small amounts while you're young and you will be doing just fine when you get old and decide to retire. The math speaks for itself.

What to invest in?

The best investment is common stock. That's the best way over the long haul to beat inflation and build up a nest egg. The market swings in a pendulum from unreasonable optimism to unreasonable pessimism, so short-term investing is pure gambling. However, if you do your research and find well-managed companies with strong market positions and invest in them over the long-term, you will tend to do well. You can lower risk further by diversifying and investing in multiple companies, of different sizes, in different industries.

But who has the time for all of that -- researching the management and business specifics of dozens of companies and staying on top of their performance and changes from day to day?

Mutual funds that invest in common stock of the types of companies you're interested in (by size, by strategy, by fundamental understanding of the value the company has to offer), if they are run by a manager with a strong track record, if they have low overhead fees and transaction costs, and if they have low turnover, can be a good way to get the diversification you want without quite so much work. They can also be a good adjunct: mixing your own common stock choices with some mutual funds in your portfolio may help protect you from the risk of your own blind spots or overenthusiasm if you choose funds whose managers' strategies are sufficiently different from your own.

Let me unpack that last paragraph. It contains the key criteria to mutual fund success.

• Read the mutual fund prospectus -- it tells you what the mutual fund is allowed to invest in, and what it has been investing in. (The name of the fund can be misleading.) The prospectus also tells you who the fund manager is and for how long.
• Fundamental value -- look for funds that invest based on the fundamental value of the company. Shy away from "technical" methods -- this means judging stock performance based on the properties of its graph, which is pure snake-oil, no matter what anyone on Wall Street tells you.
• Try for a mix of "growth" (fundamentally strong businesses poised for growth) and "value" (fundamentally strong businesses that are undervalued by the market) funds. Funds tend to have one approach or the other.
• Try for a mix of capitalizations: small, medium, and large. Some funds mix them, but many stick to one area.
• Past performance is not an indicator of future success, except when you're looking at fund managers. Find out who the fund manager is, and then find out that person's track record. This is the single most important thing to do when choosing a mutual fund. If this fund did very well over the last ten years, but the current manager has only been there one year, then find out how the fund that manager was at previously did. The fund is only going to do as well as the manager. Really good fund managers are also heavily invested in their own funds.
• Don't pay unnecessary costs. Only buy "no-load" funds. Only buy funds without a 12-b fee.
• Find out the management cost of the fund (it's in the prospectus) and don't buy unless it's under 1.2%. The lower the better. The management cost is directly coming out of your return.
• Eliminate transaction fees. If you happen to have a brokerage account, take a look at the mutual funds that they offer without transaction fees (usually a short list). If any of those happen to fit your other criteria, they might be good investments. Otherwise, go directly to the fund (they're easy to find on the web) and invest with them without a middleman. The transaction fees brokerages charge for mutual funds are outrageous. This also eats into your own returns. That's your money getting frittered away. And through the magic of compounding, each dollar saved now means many, many dollars at retirement time.
• Stick to funds with low turnover. Turnover is the percentage of the fund's portfolio that is bought or sold in a given year. Studies have shown that low turnover correlates strongly with higher performance in mutual funds over the long term. Moreover, excessive turnover will have negative tax consequences for you. The tax gains from selling a stock are redistributed out to the investors of the fund (you), so you should favor a fund that holds onto its winners as long as possible just as you would do with your own stock investments. I don't have a hard number for turnover: less than 20% is good, more than 45% is clearly bad, and in between is a grey area.
• Diversification by sector is a recipe for disaster. Stay away from funds that invest primarily in one industry, like biotech stocks or Internet stocks. These obviously do poorly when that industry tanks, but they also tend to do poorly in the long run because they've mixed investment in fundamentally strong companies with investment in weaker companies just because they're in the same industry. Yuck. My recommended diversification strategy is to mix growth and value funds, along the lines of small, mid, and large cap funds. So, six stock funds (small cap growth, small cap value, mid cap growth, mid cap value, large cap growth, and large cap value) would be a reasonable way to allocate across the range of risk and return.

I've only spoken of stock mutual funds here. Mutual funds can also invest in just about anything allowed by their prospectus and the good sense of their manager: bonds, commodities, real estate, fine art, etc. As far as stock investing goes, you should avoid stock funds that also dive into other areas of investment significantly; that fund is introducing risk into its portfolio that doesn't match your own desired area of investment.

These bullet points encapsulate what I've learned from the last year or so of active research. My goal has been every day to learn something new about personal investing. It was surprising to me that the basics of mutual fund investing aren't written down in any one place I could find. So here you go.

There's more to be said about non-stock funds, index funds, exchange-traded funds, etc. Maybe that's a future installment.

For more information I highly recommend the Motley Fool as a source of personal investing knowledge and community.