The right way to pick mutual funds
By Laura Bruce • Bankrate.com

When it comes to reducing risk in an IRA portfolio, diversity is the key. While building a broad portfolio with individual stocks is expensive, it can be done much more cheaply through mutual funds. But deciding which mutual funds deserve your cash is tough -- there are more than 10,000.

"It's gotten to the point where it's overwhelming even for an experienced investor," says David Harrell of Chicago-based Morningstar.com. "But there are fairly quick ways to scale down that universe. If you're making decisions for yourself and don't want an adviser, get no-load funds."

After that, Harrell suggests screening funds based on historical risk and return. Almost any personal finance Web site that covers mutual funds will have screening tools to help you identify funds according to performance or other investment criteria. Morningstar, perhaps the biggest and best-known mutual fund rating service, uses a star system with five stars being the highest-rated funds and one star the lowest.

"We wouldn't advise buying only five star," says Harrell. "But eliminate one and two star funds. This will get you to a much more manageable universe."

Know your financial goals
Knowing your financial goals is a critical step to building the right portfolio. What will your IRA be used for -- retirement, college, down payment on a mortgage? How long will the money be invested? You can afford to invest in riskier, growth-oriented funds if you're going to let the money sit for a lengthy period. A mutual fund portfolio held for less than five years could end up in the red or possibly just break even, according to Harrell. And, of course, with IRAs you need to be mindful of early withdrawal penalties.

You also need to make an honest self-evaluation of how much risk you can stomach. Investments aren't supposed to keep you awake at night. If you can't stand to see more than 5 percent of your portfolio evaporate during a market downturn, then you have a low tolerance for risk. Stick with conservative funds. If you could see a 15 percent loss before tossing your cookies, you have moderate risk tolerance. If you can deal with a higher loss than that, you get the iron-stomach award; you probably like tech stocks.

Many financial Web sites include risk or volatility when rating stock funds. Morningstar tracks actual investment losses over three, five and 10-year periods.

"Look at a fund's performance and see what it's done in the past," says Harrell. "If it lost 25 percent in a month three years ago it could do the same going forward."

Get beyond past performance
But past performance shouldn't be the only criterion. A common mistake people make when choosing funds is to look at lists of funds with the biggest returns last year -- and then buy them. Harrell points out that what's done well recently could easily have the lowest return in the near future; primarily because of the cyclical nature of the stock market.

Generally, the three main investment objectives are growth, income and total return. Historically, stock funds have given the greatest growth -- but they also carry the highest risk. Bond funds are good for income -- but they're not risk-free. When you buy a bond you get the principal back at maturity. With a bond fund, you get the net asset value of your shares when you cash them. Net asset value fluctuates just as any mutual fund share price -- so, you could lose money in a bond fund. Money market funds give you liquidity and safety but very little return. If you'd like to buy a fund that invests in all three categories, check out some asset allocation funds or balanced funds.

Fees and expenses associated with funds will reduce your return. The Securities and Exchange Commission Web site has a mutual fund cost calculator that can help you do some mutual fund comparison shopping. It shows the costs associated with owning various funds.

What about the fund manager?
Some investors pay a lot of attention to who's managing the fund -- there's even a philosophy that says, "Buy the manager, not the fund." The theory being that a fund's performance is driven by the manager. That's sometimes true but Harrell says it doesn't mean you should panic and sell a fund just because a manager leaves.

"It's a portfolio of stocks and the stocks don't know who picked them. A manager leaving might be an indication to keep a better eye on the fund. If a manager was simply lured away then see who the replacement is, but for a manager change in and of itself, don't pull out of a fund."

Keeping an eye on your portfolio is important. Check it every six months to see if it's on track to meet your goals. Make sure the asset mix of your mutual funds still suits your risk tolerance. And, once a year do a thorough review of your portfolio to determine if some funds should be dumped in favor of better performers.

-- Updated: April 27, 2003