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How to Pick Good Mutual Funds

by Neal Frankle, CFP ®, The article represents the author's opinion. This post may contain affiliate links. Please read our disclosure for more info.

When you consider investing in a mutual fund, one key consideration is historical performance.  That makes sense.

The only problem is that many people look at the wrong data.  As a result they can make bad decisions, and as a result they lose money unnecessarily.

If you own mutual funds, you deserve to own the best performers. I don’t think I’ll get any argument from you on that.

The question is how do you use performance data to find the top choices?

Some people argue that since most mutual funds don’t beat the S&P benchmarks anyway, you’re better off buying index funds and ETFs that mirror the S&P and be done with it. (Read “ETFs vs. Mutual Funds.”)

There is some logic to this argument, but I believe that with a little work, you can do far better. First, I’ll tell you what not to do, then I’ll explain a method you may find more helpful.

Notes:  One of the biggest mistakes investors make is they buy funds from the wrong place.  Surprisingly, one of the worst places to buy a fund is from the mutual fund company itself.

Forget Morningstar

Many people rely on a rating firm called Morningstar.  They are a very reputable firm – there is no question about it. But my experience tells me that solely relying on a Morningstar report or rating is risky.

To understand this better, you need to understand how they work.

Basically, Morningstar awards funds “stars” based on three and five-year performance. The more stars a fund has the better.  What could be more simple than that?  Nothing.

The problem is that simple isn’t always better.  In fact, in this case, those stars are based on distant past performance and therefore misleading.

The best example of this is provided if you look back to 2000. At the time, the tech stock funds had the highest rankings because their performance over the prior three and five years was through the roof.

But do you remember what happened to the market between 2000 through 2002?

It was a blood bath.  Had you simply followed the stars of Morningstar and invested in high-tech funds, you would have lost a ton of money.

As I said, from 2000 through 2002, tech stocks plummeted. You didn’t need to be a genius to realize that investing in tech funds was suicide at the time, yet these funds still carried the highest rankings from Morningstar for a very long time even after the market debacle took place.

The fundamental problem is that three and five-year history is irrelevant. Besides the fact that the market shifts much faster than that, you also must keep in mind that fund managers often change.

Think about it.  If the fund’s performance is based on the fund manager and that manger moves on, what sense does it make to evaluate the track record of the person no longer at the helm? Not much.

So how do you find the mutual funds with the best performance?

There are two schools of thought.  One idea is to use an asset allocation approach and simply use low-cost index funds or ETFs.   That’s a reasonable tactic.

There is another approach however if you want to be more proactive.  One way to find the right funds is to look at the last twelve, nine, six and three-month performance.

You can easily obtain this information if you look at Yahoo! or a variety of other sites. Or, if you have your money at a reputable online brokerage, those custodians usually have user-friendly research centers that will help you obtain the same information.

I suggest that you create your own small universe of the funds you like and continually update the trailing twelve, six and three-month performance.

You can average these three numbers, or you can weight the numbers depending on what period you want to emphasize.

Then, you can invest in the top seven funds. This is a pretty simple process.

Let’s look at a simple example.  Below, you have 4 funds you like.   In the table, you record their performance over the relevant period.

Then you total the numbers in column F.  Then, maybe you’d put 40% in Large Cap (the highest scoring fund), 30% in Small Cap (2nd best performer), 20% in International (3rd best) and 10% in Mid Cap.

Then, every month (or quarter or every 6 months) you’d re-calculate the performance and re-allocate your money between the funds.

This is just a very simple example to show you some ideas – this is not an approach I recommend or use myself. But (hopefully) you get the idea.

Of course, using this or any investment strategy won’t always lead to success.

There will be times that you will underperform the market and there will be times when you outperform. There will be other times that you beat the market but still lose money.

The nice thing about this is that you won’t be investing a lot of money in funds that are far out of favor. That is the key. And as I said, this is even more important when it comes to tax-deferred accounts.

You could have the best self-employed retirement plan or employer-provided plan but still lose a ton if you don’t select your investments carefully.

What strategy do you use when you invest? What have been the benefits and drawbacks?

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Comments

  1. King Kovacs says

    December 26, 2013 at 1:02 PM

    Sorry, have to disagree on your comments of the value (gains vs. losses) of 3-year, 5-year, 10-year performance. The combined years of gains versus losses are vital in ascertaining the long-term success of mutual funds. Of course, an investor has to include the year-to-date performance to this analysis. Without this information, how else would the average investor know what mutual funds are successful and what mutual funds are not?

    Reply
    • Neal Frankle, CFP ® says

      December 28, 2013 at 8:57 AM

      King, Thanks. I guess we have to agree to disagree. If you look at the best 3 and 5 year performance in 2000, you’d pump your money into tech funds – and stay there for a very long and painful time. I personally prefer a more dynamic approach.

      Reply
      • King Kovacs says

        December 28, 2013 at 10:38 AM

        Neal, two points to consider. First, you’re right if an individual invested solely in technology before the bubble burst that would have been disastrous. However; if that same investor diversified into several different categories such as health, equity income, mid-cap growth, etc. the outcome of loss would have been significantly less. If you currently look at the multitude of investment categories in LargeDividends.com, you will see extremely favorable results for both for short and long-term performance.

        Reply

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Who is Neal Frankle

Neal Frankle

I'm a Certified Financial Planner™ with more than 25 years of experience. I feel very blessed and hope to share my personal financial experience and professional wisdom with readers of WealthPilgrim.
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