What You Need to Consider Before Investing in a Mutual Fund
One of my friends recently said they wanted to start investing and they wanted to try out mutual funds as a first investment and asked me what they should be looking for when making a selection.
It’s a simple question, but the answer wasn’t short enough to answer in a text.
If you aren’t sure what a mutual fund is, check out this article I wrote a couple of years back: ETFs and Mutual Funds.
Questions you need to ask yourself
What is your Time Horizon?
When I am talking about the time horizon, I am talking about how long you can go without access to this money. Do you have a long time horizon like retirement where you are okay with not taking money out for 60 years? Or are you planning on using this money to buy a house in the next five years?
Your answer to this will be your first guide in your fund selection process. The longer your time horizon, investors tend to be more focused on growth. The reason is growth funds can have a lot of price fluctuation in the short-term, but in the long-term tend to appreciate exponentially in value. The inverse to that is the smaller your time horizon generally, you are looking for a more stable value fund with slight capital appreciation (increase in share price) and a little income in the form of dividends.
How much volatility can you handle?
So in 2020, I saw my portfolio drop $10,000 in one week. This did not phase me one bit. If you are new to investing or have never invested, this could give you a heart attack. So when I ask how much volatility you can handle, I’m asking how much can you watch your account drop in one day and not panic and sell?
Warren Buffet is famous for saying he didn’t lose a dollar in the ’08 financial crisis and people wonder how and he says, “I didn’t sell anything.”
Just because your account is down on paper (or now a digital screen) does not mean you lost money. But if you aren’t an experienced investor and think you will sell when you see any red in your account, I would recommend looking more into the conservative funds than their high growth counterparts.
High volatility — dramatic price swings
Low volatility — subtle price swings
What to Look for in a Fund
Now that you know a little about yourself now you can start looking at and comparing individual funds.
Side Note: If you invest in a work-sponsored retirement plan, you may have limited options of funds to choose from. So make sure you know that before doing a bunch of research on other funds that may exist.
When you look at a fund, usually the first thing people look at is performance. This is how much the fund has made over time.
Generally, when looking at a fund, it will show its performance compared to an index that it most closely resembles. If a mutual fund is comprised chiefly of stocks, it will compare its performance to the S&P 500 or other similar indexes. If the fund is more conservative, it will compare itself against a bond fund.
Mutual funds will usually list their performance over specified periods to show investors what they can expect. The time increments are as follows: Year to Date (YTD), 1-Year, 3-Year, 5-Year, 10-Year, and if it has been around awhile Life of Fund.
I tend to lean to more long-term investment, so I like to look at the 10-year performance of a fund when making selections. I don’t get wrapped up in 1-year or YTD performance which sometimes can make you think mutual funds are a get rich quick investment (psst they are not).
Always remember: Past performance does not guarantee future results.
A lot of funds will give you a gauge graphic to illustrate the estimated risk of the fund. The higher the risk, generally the higher reward. But don’t always assume that sometimes the risk is high because the investments are bad.
Another metric to look at when comparing funds is the Beta Value. A fund with a Beta of 1 will move with the market at a similar rate. A fund of -1 will move in the opposite direction at an equal rate.
What you decide on in terms of risk comes down to your risk tolerance and time horizon.
To run these funds, the companies have expenses they have to pay, and a lot of times, they end up passing this on to the customer of their fund. Luckily for many new investors, these fees have come down quite a bit due to automation and the increased popularity of passively invested index funds. There are still funds that have fees, so it is good to be aware of them.
Front Load: A fee that is charged when you buy into the fund. It is generally a certain percentage of your investment.
Back Load: A fee that is charged when you sell out of your position. The cost can fix it, or it can also decline the longer you hold onto the fund.
Loads are used to help deter investors from quickly jumping in and out of positions. The more investors a fund has that are quickly jumping in and out, the more funds they need to have in cash reserves for investors who decide to cash out their position.
Expense Ratio: This is the most common fee I have seen with mutual funds. It is a fixed percentage you pay on the value of your investment. If the fund is passively managed, you would expect a lower fee. A lot of companies are getting into the fractions of a percent range. If the fund is actively managed, you can start seeing 1% or higher expense ratios.
I am sure some people thought it would be simpler, but even after reading it I hope it didn’t deter you from giving mutual fund investing a try.
Just remember before you invest in a mutual fund or anything for that matter; know your time horizon, know your risk tolerance, and know your fees.
This is not to be taken as financial advice, it is merely financial education.