The right way to pick mutual
April 17, 2000 -- 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's much cheaper to do it 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
"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."
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."
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.
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
"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.
-- Posted April