Lessons:
About Money
101
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Guidelines for choosing stock funds1) Opt for low expenses
Fund expenses directly reduce your returns, so you'll increase your odds of success by avoiding funds with bloated expense ratios, the annual costs divided by your investment.
2) Look for consistency
For a fund to fit into a diversified portfolio, it's important
that the manager stick to particular investing style. If you
bought a fund because to you want your portfolio to include, say,
small value stocks, then you don't want a fund manager jumping
into large growth.
3) Consider risk
Returns may vary, but funds that are risky tend to stay risky. So
be sure to check out the route the fund took to rack up its past
gains and decide whether you would be comfortable with such a
ride. Here are some risk measures to consider.
- Beta measures how much a fund's value jumps around in relation to changes in the value of the S&P 500, which by definition has a beta of 1.0. A stock fund with a beta of 1.20 is 20 percent more volatile than the S&P -- ie. for every move in the S&P, the fund will move 20 percent more in either direction.
- Standard deviation tells you how much a fund fluctuates from its own average returns. A standard deviation of 10 means the fund's monthly returns usually fall within 10 percentage points of their average. The higher the standard deviation, the more volatile the fund.
- Worst quarter This is a very straightforward measure of risk: It merely shows the fund's worst quarterly return on record, giving you a feel of what to brace yourself for.
When examining a fund's performance, you should look at its long-term record (at least three years and preferably 5) versus that of its peers, as well as how it has fared over shorter stretches. And you should compare those results to category averages -- you can't really fault a small-cap fund manager for a lousy year if all small-cap funds did poorly. But it's a lot harder to be forgiving if a fund does much worse than all its peers.
5) Seek low taxes
You can't forget about taxes just because you don't have any
intention of selling your fund shares. As a fund owner, you also
own all the stocks in the fund's portfolio. If the fund manager
sells a stock for a huge capital gain, you'll have to report that
gain on your tax return. One way to keep your tax bill down is to
stick with funds that have low "turnover," which means they don't
trade a lot.
6) Steer clear of asset bloat
This is more of an issue with small-cap funds than with large-cap
funds. Since the latter buy big stocks with a lot of shares
outstanding, the manager shouldn't have too much of a problem
buying more GE and IBM as investors pour money into the fund. But
since small-cap funds are buying stocks with very few shares
outstanding, an extra billion or two in total assets can tie the
manager's hands. To put the additional money to work, the
small-cap fund manager may have to drop his standards.
NEXT: Guidelines for choosing bond funds
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