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How to Choose Mutual Funds? Reader Question

By in Advanced Investing, Asset Allocation, Bond, Investing, Mutual Funds, Reader Question, Stocks, Wealth | 10 comments

John, a loyal reader wants the answer to this common question: 

How to Choose Mutual Funds

“I would like your opinion and advice on how I should allocate my investments and my daughter’s investments among mutual funds. Both our accounts are with Fidelity. I am 56 and plan to retire at 60. I have $400,000 in IRAs (Traditional and Roth). My daughter is 24 and has $65,000 in an individual acct and $50,000 in both Roth and rollover IRA. There are so many funds to choose from and I feel overwhelmed. Any suggestions would be helpful.”

How to choose mutual funds

Too Much Fund Information is Not Always Better

There is scientific evidence that it is more difficult to make a decision when confronted with a large number of choices, than when given just a few choices. The Paradox of Choice, one of my favorite books, is devoted to this topic. The author, Barry Schwartz claims that we are paralyzed by too many choices, and that this paralysis leads to inaction. I think this is particularly true when it comes to investing in mutual funds.

Did you know there are more individual mutual funds than individual stocks? 

How is someone able to decide among the over abundance of fund offerings?

Make investing simple and learn how to choose mutual funds by winnowing the fund list and defining your risk level. 

Determine Your Risk Level First

Before considering how many and what type of funds to choose, you must figure out how much volatility or risk you can stomach. Those who cannot sleep when their investment portfolio goes up and down, should have less invested in stock investments and more in fixed or bond type investments. Additionally, the more time available before you need access to your funds, the more aggressively you can invest.

Stocks and stock mutual funds are quite volatile and over the short term (which can be up to five years) can go up or down in value. Over periods of more than ten or twenty years, their normal trajectory is upward.

Never put any money in stock type investments which you will need within the next five years.

Bonds are less volatile, yet long term historical data suggests that they offer lower levels of return than stocks. 

In general, if you are close to retirement and cautious about risk you should have a more conservative portfolio with a larger percentage of your funds in bond type investments than stock type investments.

John’s 24 year old daughter has a long working life ahead of her, time to make up any investment losses and should think about investing a bit more aggressively. His daughter can afford to invest with a greater percent allocated to stock mutual funds, because, she has decades to make up her losses.

Learn which type of investment portfolio and asset allocation is right for you.

Which Mutual Funds to Choose?

Actually, this is a much easier question than you would think. You only need a few index funds to have an optimal portfolio. Since John’s accounts are at Fidelity, I’ve included some Exchange Traded Funds (ETFs) which can be bought commission free at Fidelity. Most of these funds and ETF’s are generic index funds with low expense ratios.

Most low cost, broad based index funds of the same type are comparable. Vanguard has the largest selection of low fee index funds.

Pick an index fund from each category:

Total U.S. Stock Market Index Fund

  • Vanguard Total Stock Market Index Fund (VTSMX)-Fidelity charges a fee to buy this mutual fund
  • Russell 3000 Index Fund (IWV)- Exchange Traded Fund with no commissions from Fidelity

Broad-based International Index Fund

  • Fidelity Spartan International Index Fund (FSIIX)

Diversified Bond Index Fund

  • Vanguard Total Bond Market Index Fund (VBMFX)-Fidelity charges a fee to buy this mutual fund.
  • Barkleys Aggregate Bond Fund (AGG)-Exchange Traded Fund with no commissions from Fidelity

The percentages invested in each fund depend on your risk tolerance and preferred asset allocation. To learn more, read this free microbook, How to Invest and Outperform Most Active Mutual Fund Managers ($10.99 value). There are sections on determining your risk tolerance and asset allocation.

The most important factors in investment wealth building are to pick an asset allocation and stay invested through thick and thin. The chart of historical returns illustrates that long term asset performance is generally positive.

stock, bond, cash #investment returns

If history is any guide and if you believe the USA and world economies will continue to prosper, your investments will increase in value over time.

Caveat; This article will touch on the topics to consider when choosing mutual funds. Please do not take this as personal advice for your individual situation. There are many considerations when planning an investment portfolio. For any specific investing information, please contact your own investment advisor or CPA. Fidelity has advisors on staff that can help with investment questions as well. Personal disclosure-I have an account at Fidelity.

What are your preferred investments?

A version of this article was previously published.

    10 Comments

  1. We go with the rule of thumb to have as many bonds as your age. We are also taking advantage of our TFSA for our semi short term savings. Like you mentioned, there is not point in investing money you need within the next 5 years.

  2. Going for low cost index funds is a good approach. Remember costs matter as much as returns.

    I agree with Miss T on adjusting bond allocations according to age (and risk tolerance).

    MoneyCone

    January 11, 2012

  3. I have a mix of funds, stocks and ETFs. Some of my favorites are healthcare and biotech. As I get closer to retirement, I started to add to my TIPS (Treasury inflation protection securities) portion.

    krantcents

    January 11, 2012

  4. Miss T-that rule of thumb regarding bonds, is simple and good for those with an average risk tolerance.
    @Money-Thanks for reiterating my point about low cost index funds. Think about it, saving 1% on costs is adding 1% to returns. It adds up!
    @Krantcents-Tips and Ibonds are great for preserving the purchasing power of your cash. I wouldn’t go into any type of “bond fund” except really short term. With interest rates so low now, when they rise, the fund is certain to decline in value.

    Barb

    January 12, 2012

  5. Hey Barbara

    Good points to consider! I’m more in favor of index funds, so I look for a low fees and ease in adding funds.

    Tim @ Faith and Finance

    January 14, 2012

  6. I also like ETFs, as long as they’re commission free. Trading fees add up, especially if you’re buying or selling low dollar amounts. I’ll have to see how my Schwab ETFs have tracked against their benchmark, but so far, I like them.

  7. @Tim-Most index funds sport low fees, so I’m sure you are in good shape.
    @Shawanda-Thank you for adding the caveat, that commissions when buying ETF’s can add up. Some brokerage cos. allow commission free trading. Schwab has a nice group of ETFs.

    Barb

    January 17, 2012

  8. I think its best to stick with value oriented funds. Instead of aggressive growth oriented funds. The risk is far less investing in value stocks and the rewards just as great or greater than investing in aggressive growth stocks. Funds that invest in value stocks using classic value models tend to decline much less than aggressive growth oriented funds when theirs a market correction or a bear market. It can take years to make up a large loss so why increase your chances of a great loss in stocks when its not necessary.

    Financial Directory

    November 13, 2012

  9. @Financial-Your remarks are supported by modern portfolio theory research. Over the long term, value investment strategies outperform growth strategies. Thanks for contributing your opinion, I appreciate it. Barb

    Barb

    November 14, 2012

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