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Buying mutual funds? 5 rules to follow

August 07, 2009 15:09 IST
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Mutual funds are the right way to invest in stocks and bonds for individual investors. By following the right principles and rules, it can be both profitable and tension-free. Here are five rules for starting out right.

Rule-1: If you can afford to, build your portfolio with at least three 'core' mutual funds

The core should represent at least 50 percent of your holdings. Once you've established the core, you can build around it. But don't get carried away - just a few funds will do. Consider three areas: stocks with a large market capitalization, small-company stocks, and international stocks.

Large-cap funds should represent 50 to 60 per-cent of a long-term portfolio. If you have already started a portfolio with a balanced fund, it can serve as a large-cap core holding.

Mid-cap funds should represent up to 25 to 30 percent of a long-term portfolio. Picking a good fund in this category is one of the toughest exercises for an investor because few funds are solid long-term performers. When a fund establishes a great track record, assets explode and the manager often can't find enough good small companies to buy.

International-stock funds should represent 10 to 15 per cent of a long-term portfolio.

Once you've selected your core funds, sit tight. These are long-term, buy-and-hold investments. You should not sell them unless there is a substantial change in the fund. As your portfolio grows, you can add specialty funds around them.

Rule-2: Start with just one fund if that's all you can afford

A portfolio or group of three or more funds is ideal. But starting with just one fund is much better than keeping your money in the bank. Don't be intimidated by the suggestion that you must be an investment pro with lots of money to invest.

  • Think of your single fund as the core of what will someday be a group of funds.
  • Buy a fund that's a proven winner. Don't experiment.
  • Plan to buy and hold. You should think of investing as a long-term program.

Here are some funds for a 'starter kit':

Balanced funds:

These funds invest in both the stock and bond markets. Some require the manager to hold a mix of, say, 60 per cent stocks and 40 per cent bonds. Others give their managers more leeway. But all balanced funds invest in both markets, which makes their returns less volatile. It also keeps these returns somewhat lower than a pure stock fund's.

Index funds:

Index funds contain a mix of securities that mimics a market index. Because such a fund bolds securities in the same relative weightings as the index and trades infrequently, expenses are low. In a good index fund, returns parallel the market. Index funds work well for beginners because there is no portfolio manager to monitor.

Equity-income funds:

These are among the most conservative of stock fund offerings.

Remember, though, that you look for something different in a single fund than in a group of funds that make up a portfolio. When you begin to add funds, you'll need to take extra care to avoid overlap because your single fund probably covers a lot of bases.

Rule 3: Don't follow the crowd

By the crowd, I mean the financial press. Mutual fund news is big business for newspapers and magazines.

The result is predictable. What all publications give us now is 'the hot funds'. By that I mean the funds with the leading performance for the past six to 12 months. The leading performer is invariably a volatile fund. It can land as easily on the bottom of the heap as the top.

I've followed the crowd myself. At the end of 1995, when I was doing research to find out which U.S. fund managers had bought the year's winners in the small-cap area for an article in Bloomberg Personal Finance, Garrett Van Wagoner at Govett Smaller Companies headed the list.

Van Wagoner had established a spectacular record at Govett, with average annual returns of over 50 percent for 1993, 1994, and 1995. When I called him to find out how he did it, he told me he planned to start his own fund, Van Wagoner Emerging Growth, at the beginning of 1996.

Van Wagoner seemed credible. And the 50 percent returns seemed irresistible. I bought the fund, only to watch it turn in disappointing results that year. In 1997, the fund's results were dismal, like those of most small-cap funds that focus on the technology sector. The point is, I didn't follow my own advice and I didn't really understand what Van Wagoner was doing to achieve his returns.

So I know from experience that it's understandable to want to get in on the performance of the hot funds. But too often individual investors get in just in time for the cool-down.

By the time you read about a fund in a personal finance magazine, it's usually too late to jump on the bandwagon. Remember, too, that a fund that provides a much higher return than the market delivers a much higher risk, too.

Rule-4: Don't try to time the market - invest systematically

The equity market goes up and down in sudden spurts. But the long-term direction is up. You can stay invested and ride along the upward (sometimes rocky) path, or you can stay on the sidelines and lose out on much of the long-term return. Of course, stocks sometimes lose out to bonds or money market instruments in the short term though they are the inevitable long term winners.

The stock market's pattern is unpredictable. Forecasters talk about interest rates, employment, corporate profiles, and confidence in the economy as predictors of where the market will go. But the truth is, no one knows.

Market timers use various types of technical analysis to examine trends and look for patterns in the market. For example, many consider the movement of small investors into the market to be a signal that it's time to get out. But these market timers are often predicting doomsday while the market marches merrily ahead.

Just when things seem gloomiest - as, for example, they did in 1973 and 1974 - the market takes off. And sometimes, when market timers are predicting a correction, it seems like the good times roll on forever - or almost - as they did during the 1980s.

At the end of 1994, when US stocks finished the year with a gain of just over 1 percent, financial advisers said they fielded dozens of calls from clients asking if they should get out of stocks. Then, in 1995, the market exploded in one of its most spectacular rallies in history, up 37.5 percent for the year, followed by nearly 23 percent in 1996, and 33 percent in 1997.

Investing is all about discipline: discipline in buying and discipline in selling. The best way to discipline yourself is with a systematic investment program in which you make monthly or quarterly investments no matter what is happening in the market.

Thus, you invest the same amount of money on a regular schedule to buy whatever number of the fund's units your money can buy. Studies have shown that investors who do this end up paying less for buying each unit over time than those who purchase all in one go.

Rule-5: Rebalance your mutual fund portfolio periodically

Once you've considered your investment goals and carefully put together a portfolio, including different types of funds, is your work finished? Not quite. Even if you are a buy-and-hold investor (as most individual investors should be), your portfolio needs to be tended. Think of it as weeding a garden. You've selected the plants well, now you must control their growth. For many investors, this proves to be the toughest part.

Why? Because if you pick a winner and it takes off, chances are you feel proud of your investment prowess. Why prune it back? Because it's not giving the other funds you've invested in a space in the sun. When you put together your portfolio, you selected different types of funds that would do well in different market climates.

Left untended, your portfolio will grow toward the market sector with the best recent performance - and that's no guarantee it will repeat its performance endlessly. Chances are that as the market climate changes, the other funds may do better. Thus, the need to rebalance. The way to rebalance is to remove all emotion from it. Don't try to guess when it's time to sell one fund and buy another or to redirect your investment.

That amounts to trying to time the market, which cannot be done successfully. Instead, pick a date, perhaps the first day of the year, or your birthday, and ruthlessly prune the winners in your portfolio and add to the losers in order to rebalance your portfolio to its original weightage among the various funds.

(Excerpt from The New Commonsense Guide to Mutual Funds. Published by Vision Books.)

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