The Basics: Selecting Mutual Funds


In parts 1 and 2 we discussed risk tolerance and figuring out what asset allocation you should use. Today we will cover how to select investments to fill the asset allocation. Unless you have a background in financial analysis and selecting individual stocks (…and can dedicate a significant amount of your time to monitoring them…), I am a huge proponent of selecting mutual funds (or a basket of securities) that are managed by a professional team of analysts who monitor and research securities daily. Your research would then revolve around how to select the best fund and professional fund manager for your portfolio, in the asset class you desire.

Too many times I see individuals have a “GREAT” idea about a company (a friend recommended it or they know that the company has got something great in their pipeline) and they put 50% of their savings in 1 stock; only to later find out the stock price dropped 35% because it missed its earnings forecast. The investor loses patience waiting for the stock to turn around, and sells the stock for a loss. If you like the thrill of buying a single stock then I recommend buying those stocks with “fun” money or money that you’re are not going to save for your long-term goals (think of it like when you bet $100 at your weekend golf game or the upcoming Astros game 😉). Don’t include that fun money in your “plan” for the future. Let it be a bonus. Always remember your risk tolerance. When you buy 1 or 2 individual securities to represent an asset class it will be much riskier (it will likely have larger swings in returns), than buying a mutual fund that holds a large basket of securities. (Disclaimer: not all mutual funds are created equal. Please understand that there are some very risky mutual funds out there and you must do your research before investing in one).

On to mutual fund selection and research. I have created the infographic below for you to use in your research tool of choice to look for ideal mutual funds for your portfolio. I will dedicate a future post to reviewing available research tools on the web for you to use. Let’s just cover the criteria today. Keep learning, knowledge is key!

Definitions for you (thank you

Annualized returns: Not the cumulative return. Data sources report returns assuming reinvestment of gains, losses and income; and sometimes after fees. For periods of longer than 1 year, the returns are averaged over the time quoted; for example when seeing a 3yr annualized return. If the return quoted is not annualized it should be stated that it is a cumulative return.

Mutual Fund: a professionally managed investment fund that pools money from many investors to purchase securities. Mutual funds have advantages and disadvantages compared to direct investing in individual securities. The primary advantages of mutual funds are that they provide a higher level of diversification, they provide liquidity, and they are managed by professional investors. On the negative side, investors in a mutual fund must pay various fees and expenses.

Standard Deviation: (SD, also represented by the Greek letter sigma σ or s) is a measure that is used to quantify the amount of variation or dispersion of a set of data values.

Prospectus: a disclosure document that describes a financial security for potential buyers.

Peer group: a group of investments with similar type and asset class category. A database will track the number of funds available in a group and will allow you to compare the performance results and other characteristics of a mutual fund to its peers within the same asset class category. Often, ETFs and mutual funds are grouped together, but many databases allow you to search them independently as well.


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