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Revisiting Fund Basics: Time to Jettison Some Conventional Wisdom

Conventional wisdom often isn't. Wise, that is. When times change, basics need to change, too. Some hard-and-fast rules are as old as the days when the Dow ruled.

You hear about investing "laws" when you're getting started. But the truth is that a lot of do's and don'ts are just plain junk.

I'll admit I have been a proponent in the past of some of them. After all, who could argue with such ABCs as "diversify to avoid risk," and "it's allocation, allocation, allocation." And if my editor had asked me a decade ago to revisit my series How to Get Started at Mutual Fund Investing , I could have popped in a few new examples and pretty much kept the basics.

Not now.

Just as the Phillips curve's trade-off between inflation and unemployment -- part of my catechism in grad school economics classes -- is no longer relevant, neither are some old standby fundamentals in mutual fund investing.

So let's leave some of the conventional wisdom where it belongs -- in the last century:

1. Yesterday's leaders are tomorrow's losers.

Sorry. Not so simple. When orderly rotations were the name of the game, when retailers and financials, say, swapped places on the "in" and "out" lists every year, a lot of finger-wagging personal finance types suggested you just couldn't chase the sizzlers.

The record money flowing into the top mutual funds shows that a lot of you aren't listening, even though a repeat of the 200%, 300%, nearly 500% returns delivered by 1999's chart-toppers seems downright impossible.

There's no need to automatically assume that sizzling performance one year means you'll get burned the next. You can't even assume if technology and telecom names drop from favor, that tech-taut funds won't do well against their peers -- in my measure the most important yardstick to use when choosing a fund.

Chart-topping just doesn't send a definitive signal one way or the other. You can neither assume that a No. 1 fund will be a powerful performer over the long haul nor, say, that yesterday's leader will be tomorrow's laggard. And in neither case can you assume that fund has a place in your portfolio.

2. Read your prospectus.

Even though a push by the Securities and Exchange Commission has helped some fund firms speak English as well as legalese, few prospectuses are understandable, much less plain-talking.

It still makes headlines when a manager actually tells it like it is, such as when (IPSMX) Robert Loest readily admits in fund documents, "We buy scary stuff. You know, Internet stocks, small companies. These things go up and down like pogo sticks on steroids . . . Just so you know. Don't come crying to us if we lose all your money, and you wind up a Dumpster Dude or a Basket Lady rooting for aluminum cans in your old age."

The expense table is worth looking at -- you want to know the price tag of a fund -- but you can usually just skip the "investment objectives." They're so broad as to be meaningless. And there is often a huge disconnect between what a fund is allowed to do according to its prospectus and how the manager really invests.

Plus, these documents don't even try to tell you how a fund compares to peers (unless of course, it's beating them) and how the fund performed in down periods.

Call a shareholder representative and ask for the fund's performance for a time period that concerns you, such as this quarter, for example, or the second quarter of last year. Or you can rely on TSC or fund-rating companies like Morningstar to give you the goods. But don't waste much time reading the official literature. You simply will not find the information you need to make an informed investment decision.

3. Forget the rookies -- go only with long-term records.

A long-term record is often considered a hard-and-fast prerequisite when choosing a mutual fund. Naturally, you feel a lot more comfortable investing in a security that can show what it has done for an extended period, in good times and bad.

But while a three-, five-, even 10-year record does offer valuable information about how a fund performs long-term, remember that a decade ago "Internet" was a word rarely uttered by anyone but Al Gore and that computer nerd who actually liked your college statistics course.

I admit it -- I like rookies. Of course, what's acceptable on the playing field isn't always proper in a portfolio, but ruling out a rookie may mean missing out on some real performers. There are a few well-documented, built-in advantages to newer funds: Managers can start from scratch with their best ideas. Assets are fewer, so the fund can be more nimble getting in and out of stocks. New funds at big families often get their first crack at hot new issues. And cash flow tends to be steady at first. A slew of studies has shown that younger funds tend to have a "first-year" effect, outperforming their older peers.

But most importantly: Can you say "Internet?" If you want to make a pure bet on the sector, you can't find a fund with more than a few years of record.

So while you may choose to take comfort in an established performance record, I still think it's possible to get to know a rookie well enough to buy it. Especially if it's "all in the family" and a strong fund firm with a great bench, such as Janus, opens up a new fund.

So there you go -- toss those standbys in the trash. Others still stand. I think for most of us, trading funds makes no sense or money. And even though the 60/40 rule of stocks to bonds hardly holds anymore, you can't just say goodbye to the concept of diversification. In the next two weeks, I'll give my guidelines for buying and selling funds -- as well as take a look at the four-letter word in many investing circles -- risk.
Brenda Buttner's column, Under the Hood, appears Thursdays. At time of publication, Buttner held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While she cannot provide investment advice or recommendations, Buttner appreciates your feedback at TSCBrenda@aol.com .

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