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How to Sail Through the Sea of Mutual Funds

When you try to choose a mutual fund to invest in, it can be an extremely daunting task.  It’s easy to get lost in the sea of choices between thousands of mutual funds and tens of thousands of share classes.

Many investors often cling to the nearest lifeboat they see, which often times is a decision based on performance.  The problem is that those rafts can quickly deflate as performance is never a good long-term determinant.

So how can you ensure that you have a stable boat that will carry you through the towering waves of mutual fund choices?  Well, there are a few different aspects of the decision to consider before you hop aboard.

Are you seaworthy yourself?: It’s important to know yourself and your comfort level in the rough waters that mutual funds can bring.  Can you handle the stress that comes with the shifting performance of many funds?  Mutual funds can at times require a lot of patience and confidence for investors to wait out small dips for the long-term positive performance.  You also need to take your morals and values into account when choosing a company or industry to invest with.  Make sure your ethics match those of the mutual fund you invest with.

Understand the variety of vessels: Portfolio performance is often determined by how the assets are allocated.  You need to understand the different fund styles.  Take a look at the characteristics of the different fund classes, such as small-cap, large-cap, blend funds and so on.  Once you know the specifics of each of these, determine which ones match the investments that you are looking to make.

Be Aware of the Ebbs and Flows: Performance of the fund is something to consider when you are choosing where to invest, but many financial professionals warn of the cyclical nature that most funds follow.  It’s important that all performance statistics be examined with a critical eye.  Jumping into a fund when it’s at its height leaves you with a long way to fall.

What’s the cost of a ticket?: Fees are one of the most dividing issues when it comes to funds. If the fee on one fund is higher than another, that fund must make up the difference in performance, which is often hard for managers to do.  Index funds usually offer lower fees than funds that are actively managed, which aim at making up for the fees with stock choices.  Overall, fees are something to evaluate near the end of the process.  They shouldn’t make or break your decision, but they are something that can drastically affect your performance and should be taken into consideration.

Watch for people jumping overboard: The turnover rate of a mutual fund is one of the best indicators as to how successful the investment will be.  This rate signifies how many of the holdings in a portfolio have changed over that year, in a percentage.  Those rates can be anywhere from less than 10% to over 300%, depending on how aggressive the fund is.  The higher the turnover, the higher the cost from the frequent buying and selling and other movement efforts.  It’s best to target funds with a lower turnover, aiming at 40% or lower in order to avoid the issues that constant trading has on longer term performance.

Become familiar with the captain of the ship: Another aspect of the fund that you don’t want to see turning over is the fund’s manager. The stability of a fund can be read by the stability of its manger.  In order to prove worthy of their role, fund managers must show that they are capable of maintaining a consistent style and discipline in the decisions involved with the fund.  It’s nearly impossible to predict the future success of a fund if the manager role has endured frequent changes.  A good rule of thumb is to find a fund whose manager has been in that position for at least five years to ensure that any patterns will continue to be consistent.

Is the ship on course?: A strong fund will follow its strategy through thick or thin.  The overall course of a fund shouldn’t change based on market changes.  Of course, the ability to adapt to changes is a positive tool in mutual funds, but the overall strategy and plan of a secure, strong fund should always keep its general course.  Be wary of funds that seem to jump on the bandwagons of investment fads which make them stray from their original direction.

The waters of mutual funds can seem endless and dark at the beginning, but by sorting out a few basic issues involved you can find yourself smooth sailing in no time.  Of course, even the best planning can’t guarantee that you won’t run into a storm or two along your journey.  But the stronger and more secure your mutual fund of choice is, the higher the probability that you’ll weather the storms and sail off into the sunset.