The biggest mistake a person can make when trying to put together a portfolio on their own is picking an investment of any kind before do any due diligence. This due diligence involves researching the stock, bond, mutual fund, ETF, etc. but more importantly, it involves honest research of oneself. If this is not done correctly, an investment decision could have disastrous results.
The following questions need to be answered before someone ever types in a ticker symbol on a website or flips through the performance section of Barron’s Magazine:
– What is my time frame?
– What is my risk tolerance?
– What is my objective?
Time Frame There is an extreme difference between someone who is saving money to buy a house in 18 months compared to another who is looking to use the funds for retirement 20 years away. The general rule of thumb in the financial industry is that any time-frame over 5 years, is considered long term. 5 years is usually a suitable length of time to ride out any fluctuations in the market. The shorter the time frame from 5 years, the more conservative the investment should be.
Risk Tolerance This tends to be the most difficult answer an individual has to answer. The two biggest enemies to investing are fear and greed, and the both rear their ugly heads when trying to decide what will keep you awake at night. It is very easy to say you are an aggressive investor when the stock market is up 30% in one year. The more important question you need to ask yourself is “how would you feel if that same investment was down 20% the next year?”
Objective Are you looking to put money in an investment and let it grow for 20 years or are you looking for something to generate income? Could it be a combination of the two? Maybe you’re just looking to protect what you already have?
Now that you’ve answered these questions about yourself, now you can begin to search for a mutual fund. Be careful where you look for information. There is so much out there, and you want to make sure you are getting an objective opinion. You also want to make sure you are choosing a fund for the right reasons. There’s a saying in the financial industry”Yesterday’s winners are tomorrow’s losers.” Just because a mutual fund was up 19% last year, it does not mean it is the right investment for you. Performance, in fact should be one of the last reasons.
So you want an objective opinion and you want more information than performance. One of the best places to get the kind of information you are looking for is www.morningstar.com. There is a premium service there, but everything you need is right there and free. The questions you want to ask now are:
– What is the objective of the fund?
– What does the fund invest in?
– What is the Morningstar rating?
– How old is the fund?
– How long has the portfolio manager run the fund?
– What are the expenses of the fund?
Fund Objective Each fund must list their investment style and is also categorized by their investment objective. If, after answering the above questions, you have found that you are a conservative investor, you do not want to invest in a mutual fund that focuses on small companies in emerging markets. You want to match your objective to that of the fund itself.
Investment Category – Mutual funds are categorized by the investments they use and where these investments are. Short-term fixed income funds are different than European technology funds. Many of the most popular funds fall into the category of US Large Cap, which means the fund invests in American companies with large capitalization. These companies are the household names you hear every day.
Morningstar Rating Morningstar uses a five star rating system where they compare each fund to its peers. They compare apples to apples and not oranges. Make sure when you are comparing funds that they are the same category and objective.
Life of fund/Portfolio Manager Tenure Because all you have to compare investments is past history, you want to make sure there is a legitimate track record and that the same portfolio manager has run the fund over that period. A five year time-frame is usually a long enough length of time to make any judgments.
Expense Ratio The more expensive it is to run the fund, the higher the expense ratio. The higher the expense ratio, the more it affects the performance of the fund. A fund that has 3.00% in expenses will have its performance diminished compared to one with lower expenses. It still may be the right fund; you just want to be aware of this.
Once you answer all of these questions, you will have narrowed down the list of over 10,000 mutual funds to a small handful. Now you can use performance to make a decision. However, that decision is never final. It is of utmost importance to keep track of you investments and if any changes are made to them. If you do not have the time or resources to do that, you may want to hire someone to do it for you.
This is a lot of information, and may be a little overwhelming, but so is the idea of preparing for you future. It should not be taken lightly. Hopefully after reading this, you will feel a little more prepared.