My monthly column in ACEP NOW is on choosing the right mutual fund. Many investors mistakenly skip the pre-requisite steps of setting goals and developing an asset allocation and hope to simply pick some good funds out of their 401(k) to invest in. It’s not surprising that their investment returns reflect the fact that they aren’t actually following any kind of a reasonable plan. In this article, I discuss five things you should be looking at when implementing your asset allocation in your 401(k) or IRA. I hope little of it is new information for long-time readers, but keep in mind it is written for a much broader audience. Here’s an excerpt:
Step 1: Match Funds to the Asset Allocation
This might seem obvious, but many investors seem to get it wrong. If your hypothetical asset allocation plan calls for 30 percent of your portfolio to be invested in U.S. stocks, 30 percent in bonds, 20 percent in international stocks, 10 percent in real estate, and 10 percent in small value stocks, then you just need to select one fund for each of those categories.
When evaluating a mutual fund, the first consideration is to determine which assets the fund actually holds. If you are looking for a fund for your U.S. stock allocation, you do not want to look at a balanced fund (contains both stocks and bonds) or an all-world fund (invests in both U.S. and international stocks). Likewise, if you want a broadly diversified international stock fund, you can eliminate funds that invest solely in Japanese stocks, European stocks, or Brazilian stocks. This information can easily be found in the first few pages of the prospectus, on the fund summary page on the fund’s website, or on an independent website like Morningstar.com.
Step 2: Avoid Playing the Loser’s Game of Active Management
All mutual funds are managed by professionals. However, the mission of most mutual funds is to “beat the market,” outperforming an index composed of all of the stocks (or bonds) in a particular asset class. The managers of these active funds try to buy investments likely to go up in value and sell investments likely to go down in value. Although it seems intuitive that highly trained, hard-working professionals could easily do this, it turns out to be extraordinarily difficult to outperform the market in the long run. Very few active managers will do this over any given period, and there is no reliable way to select them in advance.
According to data published in Allan Roth’s How a Second Grader Beats Wall Street, a typical actively managed mutual fund has about a 38 percent chance of beating an appropriate index in any given year. Over five years, that falls to 22 percent, and after 25 years (a typical physician career length), it is just 1 percent. In a five-fund portfolio, the chances are even worse, about 20 percent in any given year and 7 percent after five years. The solution to this dilemma is to avoid playing the game at all despite all the time, effort, and money spent by financial institutions trying to get you to do so.
Read the rest of the article here, and then come back and leave a comment telling me what you thought. When faced with dozens of funds in your 401(k), how do you choose which ones to use? Comment below!