Question. I feel overwhelmed when I see all of the mutual funds available in my 401(k). How can I choose the right one?
Answer. Mutual funds are an excellent way to invest in stocks, bonds, and other securities. Mutual funds provide for broad diversification, economies of scale, and professional management not available to individual investors selecting securities on their own. This task can be delegated to a competent advisor, but even if you use an investment manager, understanding this process will allow for evaluation of an advisor’s advice and performance.
Prior to evaluating a mutual fund for inclusion in your portfolio, it is important to first complete several prerequisite tasks. These include setting appropriate goals, developing an overriding investment plan (asset allocation), and selecting the most appropriate and tax-efficient combination of investing accounts (such as 401(k), Roth IRA, or a taxable brokerage account). Deciding on an asset allocation (what percentage of your portfolio to invest in each asset class) can be a difficult decision, but once completed, selecting appropriate mutual funds to fulfill the chosen asset allocation can be ridiculously easy.
Step 1: Match Funds to the Asset Allocation
This might seem obvious, but many investors seem to get it wrong. If your hypothetical asset allocation plan calls for 30 percent of your portfolio to be invested in U.S. stocks, 30 percent in bonds, 20 percent in international stocks, 10 percent in real estate, and 10 percent in small value stocks, then you just need to select one fund for each of those categories.
When evaluating a mutual fund, the first consideration is to determine which assets the fund actually holds. If you are looking for a fund for your U.S. stock allocation, you do not want to look at a balanced fund (contains both stocks and bonds) or an all-world fund (invests in both U.S. and international stocks). Likewise, if you want a broadly diversified international stock fund, you can eliminate funds that invest solely in Japanese stocks, European stocks, or Brazilian stocks. This information can easily be found in the first few pages of the prospectus, on the fund summary page on the fund’s website, or on an independent website like Morningstar.com.
Step 2: Avoid Playing the Loser’s Game of Active Management
All mutual funds are managed by professionals. However, the mission of most mutual funds is to “beat the market,” outperforming an index composed of all of the stocks (or bonds) in a particular asset class. The managers of these active funds try to buy investments likely to go up in value and sell investments likely to go down in value. Although it seems intuitive that highly trained, hard-working professionals could easily do this, it turns out to be extraordinarily difficult to outperform the market in the long run. Very few active managers will do this over any given period, and there is no reliable way to select them in advance.