We all know the advantages of investing in a mutual fund versus trying to pick individual stocks. First, mutual funds hire professional analysts that are stock market gurus and devout their working life to studying various stocks. So unless you want to devout a large portion of your current free time to the study of financial reports, you probably won’t have a chance of beating the return of a mutual fund manager.
Second, there is the well documented advantage of diversification. Your overall risk is reduced by holding several different investments. Put simply, some stocks will go up in price and some will go down, but overall, when combined, the return should be higher than any other form of investing.
Third, a mutual fund offers small investors a chance to invest in smaller increments over time, rather than having to save a large chunk of cash to purchase individual shares of stock.
Given the above advantages, plus the fact that almost all 401(k) plans make you choose mutual funds, it’s no wonder that mutual funds have become the most popular form of investing in the stock market. Now that there are only 6 million mutual funds to choose from, so how someone make the right selection? Here are a few tips:
1. Do not be tempted to jump in on the hottest performing fund of the year. It may seem like rational thing to do, but like individual stocks, you want to buy low and sell high, not buy high and pray for higher.
2. Even the best run funds may not be able to overcome the force of the overall market. This is why I talk about ETF's being a better option in my book, Start Winning With Money. They cost a lot less to hold in your portfolio, and you can purchase 2-3 in order to perform with the overall stock market. But since we have to buy mutual funds within a 401(k) plan, you should be looking for funds that have a long term record (10+ years) of exceeding the broader market.
3. Limit the number of funds that you own in your portfolio. 5-7 funds should be more than sufficient. Diversifying into too many mutual funds will not reduce your risk any better than having too few mutual funds. Your returns will not increase by much more either.
4. Funds that become popular and too big to manage tend to slip in performance later on. There are several reasons for this, but the primary reason is that a fund manager is often forced to spend money on stocks even if he/she believes they are overvalued.
One final point to keep in mind is that the type of mutual funds you purchase will depend on your investment objectives. There are certain funds that are designed for your financial objectives in life, be that retirement, income, growth, funding the kids college, etc.