Mutual funds have become the investment of choice for millions of individual investors. Unfortunately, with a frustrating stock market, international instability and questionable corporate practices, too many people are making it worse by following their emotions rather than using common sense."As a financial planner, I frequently see people who have ruined their portfolios by selling at the worst possible time, then buying again after everything has gone back up" says Tom Wade, a Certified Financial Planner and professional portfolio manager.
Individuals can benefit from a few simple rules, thereby avoiding the most common mistakes.
It is very common to purchase a mutual fund based on its past track record. This is only natural. However, the conditions that cause a fund to be last year's big winner may not be in place today. As a result, it is very rare for a top fund to be on top more than one year in a row. In fact, because of huge inflows based on performance, often a fund manager is swamped with cash and can't possibly achieve the same results. The better strategy is to aim for consistency in performance and management, rather than trying to hit the home run.
There is significant emotion involved in financial matters. This often results in making investment decisions for the wrong reasons. Investment hype on television or the Internet is often enough to sway a person into buying or selling impulsively."The best course is a methodical, well-planned strategy, designed to weather the storms, while taking advantage of market advances" Wade points out.
"Portfolio construction, starting with a solid foundation can be accomplished using stable, large company funds or index funds." Wade said."The aggressive stuff should be limited to 10% or less, and for most people avoided altogether."
Instead of adhering to a disciplined strategy, it is common for people to buy fund after fund, ending up with a "collection" of mutual funds. "Five to seven funds is generally enough to get the diversification needed, after that the Law of Diminishing Returns comes into play" Wade adds. This over-diversification is dilutive, having a negative effect on the results.
Another problem arises when an individual buys a number of the same type of fund. People buy what they like, and if they like large-cap growth funds, it is not uncommon to see several large-cap growth funds in the same account. The result is excessive overlap. Remember that mutual funds charge fees, and you are paying an average of 1.5% per year for each fund.
It is not easy for the average investor to know what each separate mutual fund is investing in, and therefore it is hard to know when the management is straying from its charter. Annual and semi-annual reports can help an investor review the largest positions a fund holds, to get a sense if the fund is still accomplishing its mission.
Management changes, significant portfolio modifications and fee alterations should be watched carefully. These are signals that the fund is different than when it was purchased, and it should be determined if it still fits into your overall portfolio strategy.
Professional money managers realize that the single most important determinant to portfolio return is being in the right asset class at the right time. For example, owning bonds as interest rates are declining, or investing internationally as the US dollar is falling against other currencies. However, no one knows which sector or category will be the next big winner. Therefore, maintaining a diverse mix of asset classes and rebalancing periodically will help investors stay the course without taking excessive risk.
I recommend a variety of index funds for low cost, tax-efficiency and market-level returns, while avoiding bond mutual funds which could decline significantly in the event of future interest rate increases. "Investors should first outline their long-term needs, quantify their risk tolerance, and not react emotionally to the constant stream of negative news" Wade said."Maintaining a healthy dose of objectivity, rather than emotion, will guide you in the right direction."
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