Four Steps To Finding The Right Mutual Funds

Finding the best mutual funds is an art and a science. It is an art in that it’s subjective – a fund that suits you may not be the best choice for your neighbor. But there is science to it as well. Granted, there is no formula that can predict which funds will perform best over the next year or longer. In order to do that you’d need a crystal ball. But once you are clear about your own objectives, you can review the fund’s performance data and pretty easily determine if it is a good fit for you or not. Let’s get cracking.

1. Your Objective

• Are you looking for growth
• Is it income you are most interested in?
• What is your investing time-frame?
• How much risk are you willing to take in any given year?
• Are you going to monitor and adjust your fund choices? How often?

These are all questions you have to answer before even leaving the gate. My experience is that many people don’t do this. As a result, they just pile into the hottest fund they can find and often become disillusioned when the market turns tail.

New Resource – Before investing a dime, make sure you know your risk comfort zone – and then find out how much risk is in your portfolio and in the fund you are considering buying.  Here’s a free tool to help you gauge your own risk comfort zone.   Once you take this 3 minute survey, you’ll know where you stand.  Then, let me know and I’ll be happy to run a scan on your portfolio to see if there is a match or not.

2. Your Account

It shouldn’t be this way but often the mutual funds which are made available to you depend on where you open your account. That’s why if you are a DIY investor, I always recommend using an inexpensive broker that offers the most fund choices possible. And I usually suggest that you stay away from opening an account directly with a mutual fund company.

For example, if you open an account at Vanguard, you may only be able to buy Vanguard funds. Don’t get me wrong, Vanguard has some fantastic funds. But other companies offer great alternatives as well. Why restrict yourself to only one family of funds? To me it doesn’t make sense.

3. Your Universe

Now that you’ve identified what you want to achieve and you’ve set up your account, it’s time to create a universe of funds that potentially fit the bill. There are two free online tools that might help you do this. One is over at the Wall Street Journal’s site and the other is provided by Morningstar.

Let’s look at the WSJ’s screener to get a better idea of how you might create your own fund universe. Keep in mind that you are only trying to create a pool of funds to select from at this point. You aren’t trying to screen down to your final choices – we’ll get to that later. My suggestion is to whittle your list down to 25 to 30 funds and no fewer.

The top arrow on the right is the section where you screen for equity, fixed income or tax-free fixed income. To the right is “Lipper Category” highlighted in yellow by yours truly. You can screen very narrowly under Lipper Category but for most people I suggest you scroll down and select the S&P 500 filter. If you do this, you’ll screen for funds that did well relative to the broad S&P index – Bueno.

Next look at the Lipper Leaders (the second red arrow on the bottom left). Keep in mind that you want a decent size universe of funds to choose from as I said. With that in mind, you might want to accept the best 2 or 3 levels rather than just the top level funds.

Keep in mind that these Lipper ratings are relative and awarded at just one point in time. If you take the top few levels, you have a better chance of having great funds in your pool even if they aren’t doing the very best at this exact moment in time.

From here on you can continue to narrow down your universe of funds using the technical filters provided by the site. Personally, I don’t find these additional screens that useful but obviously you are free to use them.

4. Narrow The Field

Once you’ve created your fund universe it’s time to pick the funds that best suit your particular requirements for growth potential and risk reduction. The best way to do that in my experience is to look at the year-by-year returns on your funds compared to the market indexes.

Note – it’s very important to look at the year-by-year returns rather than use 3, 5 and 10 year averag.  This step is really important. When you look back over the last 10 years and see how your fund performed in each year compared to the market, you get a sense of how well your fund did in good years and how poorly the fund did when things were rocky. This in turn helps you understand what kind of ride you sign on for when you buy any particular fund – and how much risk you could be exposed to.

Finding the right mutual fund isn’t that difficult. The process I detailed above will help you do just that. Of course there is no guarantee that any particular fund picking method will result in outsized gains or shield you from losses. But a process such as this is a good way to do your homework and find funds to that make sense for you.

Do you use any of the methods above when you buy mutual funds? If not, how do you select your funds?