Mutual Fund Monday - Beverly Goodman

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New Year's Resolutions for Fund Investors

Beverly Goodman

Forget about those last five pounds and the work that needs to be done on the house -- it's time for some New Year's resolutions that you really need to make.

The new year is the perfect time to get your finances in order. Perhaps you've once again broken the bank on holiday gift-giving; perhaps you stayed within your budget. Clearly, you'll need to tackle any immediate cash-flow issues first. But once that's taken care of, turn to your portfolio and make sure it reflects your future, not your past. To that end, we offer a few resolutions that you can actually stick to. And if you put the work in now, you won't have to do anything beyond an annual checkup.

I will make my portfolio signal my current goals, not past mistakes. It's easy to be laggard regarding your portfolio's asset allocation, but few elements of money management will do more to ensure you meet your immediate and long-term goals. Make a list of all your accounts and note how they're allocated. Next make a list of your goals. Everyone should have at least three to six months' worth of expenses in a money market account -- more if your job is closely tied to the economy or if you anticipate a rocky time for other reasons. (Tenured college professors have less to worry about than computer consultants do, for instance.)

Once you've sliced off your emergency fund, take a look at the rest of your portfolio and see if it's in line with your goals. If you already own your home, don't anticipate sending kids to college in the next 20 years and won't retire for another 30, you can afford to keep a healthy portion of your portfolio in stocks. But any money that you expect to need in the near term -- no matter what you'll need the money for -- should be in less risky investments, such as bond or hybrid funds.

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This is also a good time to weed out any useless funds. The less money you have, the fewer funds you need -- but even huge portfolios rarely need more than eight funds. Start off with one broad market stock fund and one broad market bond fund. Then think about splitting your stock investments between growth and value; large- and small-capitalization stock funds. At that point, consider adding an international fund for added diversity. Your bond portfolio can be divided between Treasuries and corporate bonds. But don't feel like you need to go that far -- most investors can meet their goals with just a few funds. Fewer funds means lower expenses, less to keep track of, and less temptation to yank your money around. Which brings us to the next resolution...

I won't chase returns. Everybody knows that chasing returns is a loser's game. The problem is, most people don't realize that's exactly what they're doing when they hear that bonds are hot and flee their stock funds. "Fund flows are always a lagging indicator," says Morningstar analyst Scott Cooley. "By the time individual investors make a decision, the market's usually about to turn." Cooley points to 2000, when the stock market began its breakneck fall, and equity funds showed record inflows throughout the year. Not surprisingly, we had also been in a bear market for a couple of years before people started pulling their money out of stocks.

Money management shouldn't be reactive -- that's the main point. Plus, when you factor in trading costs, load fees, taxes and expenses, bouncing in and out of funds will almost certainly never pay off.

I won't be swayed by the latest hot fund managers. You know the names -- Bill Gross, David Tice, Bill Miller. Those are today's stars. A few years ago it was Kevin Landis, Garrett von Wagoner, Alan Harris. These guys are more than just telegenic with pithy market observations at the ready -- we'd venture to say they're pretty smart. But even the smartest money managers aren't right all the time; and what's more important is that they don't manage money the way you should. These folks are making big bets, largely hoping for short-term gain. Individual investors are making relatively small bets and should be focused on long-term returns.

So while you can drink in whatever the talking heads have to say, keep in mind that no matter how prescient past comments seem to be, or how much you instinctively agree with what they're saying, that's not enough of a reason to pour money into their funds. Take a more circumspect view of your portfolio.

I will pay attention to taxes and expense ratios. It's hard to say which can do more damage to your portfolio -- poor internal tax management or high fees. A study released in August by Lipper, a Reuters company, documented that investors needlessly give up as much as 23% of returns to taxes. That's an astounding figure. Investors, the study found, give up an average of 1.3 to 2.5 percentage points annually to taxes. That translates to as much as 23% of the return (in dollars) getting wiped out by taxes every year.

High fees, though, can do a number on your returns as well. Low expenses are one of the major reasons that stock pickers have such a tough time beating index funds. Even if a manager can actually beat the market every year (as measured by the S&P 500 or Wilshire 5000), the price you pay for active management at best mitigates -- and often wipes out -- any so-called outperformance.

Expenses are more important than ever these days, when the stock market isn't expected to return more than 5% to 7% in the next few years. The average U.S. stock fund charges 1.45% a year to manage your money, although stock index funds often charge nearly half that. Which brings us to...

I will invest in index funds. Time after time, research has proven that index investing trounces active management -- always over the long haul, and usually in the short term as well. But for those of you who need a refresher, Vanguard has just examined the first 11 months of 2002 and found that index investing beat active management in seven out of nine categories. One category in which active management beat indexing -- large-cap value -- did so by less than 1.5 percentage points. (Remember what we just said about fees?) Active management in the small-cap value arena beat indexing by just over 5 percentage points.

Index funds are more tax efficient and cheaper, and they generally lock you into a broad and diverse array of stocks -- all good things. And that's exactly what you want to start the year with.