Mutual Fund Investing For Dummies

Mutual funds are by far the most effective tool average Americans have for achieving financial security.  Diligent saving and a reasonable, disciplined investing strategy over the long term should in most cases result in a comfortable retirement.  Sure, sometimes life gets in the way of retirement savings but by and large the vast majority of Americans have more-than-adequate resources to achieve financial security by the time they reach retirement.

Mutual Fund Investing 101

Mutual fund investing isn’t difficult.  You can create a simple, excellent portfolio yourself capable of outperforming the vast majority of professionals with as little as 3 or 4 funds.

Determine The Right Mutual Fund Mix

Approximately 90% of a given portfolio’s returns are determined by one thing and one thing only:  asset allocation.  The remaining 10% is determined by specific fund choices, investment costs, and timing.  Since asset allocation plays such a huge role in determining your portfolio’s future returns, you should take great care to make sure you get it right.  An in-depth analysis of the principles of asset allocation is beyond the scope of this article, but two books on the subject I very highly recommend are All About Asset Allocation by Rick Ferri and The Intelligent Asset Allocator by William Bernstein (slightly more advanced).  Suffice it to say I believe you should do your research and determine a reasonable asset allocation plan before investing a single dime in mutual funds or any other investment.

Stick To Low-Cost Index Funds

Low-cost index funds should form the core of everybody’s portfolio.  They are the cheapest, most direct, and easiest way to gain access to any given asset class.  And since investment costs are the most reliable predictor of future mutual fund performance, index funds have a built-in advantage over actively-managed mutual funds.  That said, most investors just can’t resist trying to pick a winning mutual fund.  There’s nothing wrong with this approach so long as you a.) realize you’ll most likely under-perform the market and b.) limit actively-managed funds to 10-20% of your total portfolio (if possible).

Be Cognizant of Taxes

Probably the most common “gotcha” of mutual fund investing is taxes.  Some types of mutual funds are simply more tax efficient than others, and how you distribute various investments among various account types (called asset location) can be almost as important as asset allocation once your portfolio becomes large enough.  In general, equity index funds and tax-free municipal bonds belong in taxable accounts while taxable bonds, real estate, commodities, and actively-managed funds are both held inside a tax-advantaged account such as a 401k or IRA.

Stay Disciplined

Successful mutual fund investing isn’t difficult, but it does require a surprising level of discipline.  If you don’t invest regularly or panic and sell out at the lows (as opposed to staying the course), your odds of success decrease dramatically.  More important than devising the perfect plan is simply sticking with any plan, even a mediocre one.  I’d wager a bad asset allocation plan, faithfully followed in the good times and bad, will out-perform an excellent plan only half-heartedly executed any day of the week.

Keep It Simple

The financial media has a vested interest in making mutual fund investing seem hard.  After all, who would buy their publicans and services if they knew how easy it was to invest profitably?  Diversification is a beautiful thing, but in the real world the benefits of further diversification begins to taper off after you already own three or four different asset classes.  You should aim to own at least the four basic asset classes:  domestic large-cap stocks, domestic small-cap stocks, foreign stocks, and bonds, but after that the benefits of diversification begin to diminish significantly.  Yes, you can and probably should own both real estate (I do) and commodities, but the additional diversification benefits of adding your fifth and sixth asset class is relatively small compared to the benefit of adding your second and third.

Stay Informed, But Not TOO Informed

It’s a good idea to sign up for a free Morningstar account and check up on how your funds are doing occasionally (manager changes, recent tax-efficiency ratings, expense ratios, etc), but don’t overdo it.  The urge to tinker with a good portfolio in pursuit of a great portfolio can be a recipe for disaster.  Similarly, while it’s nice to have a general notion of how well your portfolio has been performing lately, you shouldn’t obsess over it.  If you’re checking your balance more than once or twice per month, you’re probably over-analyzing things.  If this is money you won’t need for the next 30 years, why does it matter what the balance next week is?