John, a loyal reader wants to know how to choose mutual funds.
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.”
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) and 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.
Many financial professionals recommend that those younger than 40, who are saving for retirement should allocate up to 90% of their investment dollars into stock funds. I’ve never been that aggressive, yet, probably should have been.
Had I invested more heavily in stock funds in my younger years, my net worth would be greater today.
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The most important factors in investment wealth building are to pick an asset allocation and stay invested through thick and thin. This chart of historical returns illustrates that long term asset performance is generally positive.
So now that you have the asset allocation basics, on to which funds to choose.
Which Mutual Funds to Choose?
When choosing mutual or exchange traded funds (ETFs) narrow your universe first. Research is abundantly clear, passive index fund investing outperforms most actively managed funds. So, your first mutual fund selection activity is to eliminate actively managed funds from your choice.
Depending upon where your account is managed; Fidelity, TD Ameritrade, Vanguard, Schwab or other, many of these investment houses offer commission free index ETFs and mutual funds.
Check out the fees of the funds and strive for a reasonable level of diversification.
Here’s my Friedberg Family Portfolio. We own funds and asset classes than many, but all of the them are passively managed index funds with low fees (except a few within workplace 401(k)s with limited investment options).
Actually, choosing a mutual fund is a much easier task 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.
For more investment ideas read: My Best Lazy Investment Portfolio
Most low cost, broad based index funds of the same type are comparable. Vanguard has one of the largest selection of low fee index mutual 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.
- Barclays Aggregate Bond Fund (AGG)-Exchange Traded Fund with no commissions from Fidelity
If you want to get fancy, you can diversify a bit more with a real estate investment trust (REIT) fund. Or, you might consider a mid-cap or small-cap index fund.
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.
Although no one knows what the future holds, 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 and other investment companies have advisors on staff that can help with investment questions as well. Personal disclosure-I have an account at Fidelity.
What are your preferred investments?
Updated October 27, 2018.