You've heard of the "smart money." Well, there's a phenomenon that can be called "dumb money." It seems especially pronounced among mutual fund investors, who are a little too fond of putting their money on automatic pilot.
Below you'll find a debunking of common misconceptions about mutual funds and a checklist for assessing and picking the mutual funds that are right for you.
It's difficult for humans to avoid the herd mentality. After all, they are social animals and as such, take their behavioral cues from others. This lemming-like tendency is glaringly apparent when it comes to mutual fund investing, which by its nature attracts investors who like to leave the analysis to others.
As super-investor and Berkshire Hathaway (BRK.A) - Get BRK.A Report founder Warren Buffett aptly put it: "Nothing sedates rationality like large doses of effortless money." That's why it pays to follow the buying-and-selling decisions of Buffett.
No matter what your investment goals or time horizon, you should always apply your own rational analysis when it comes to your savings. As you analyze the plethora of mutual fund alternatives, don't fall for what may be the three most prevalent mutual fund myths:
1) Mutual funds always are long-term investments, suitable for retirement. Invest in them and forget them, until you need the money.
This is false! Many fund managers run their respective funds with short-term goals in mind. If you don't regularly monitor your fund and change course when warranted, you could be left with a poor investment.
2) As fund assets increase, mutual fund costs will decline.
For most funds, this has yet to occur. As they've grown bigger, many funds continue charging higher fees.
The investment industry continually pushes the myth that the statistical law of large volumes, when applied to mutual funds, will protect the average individual investor from paying too much. The theory says as a fund's assets expand, each individual becomes responsible for a shrinking percentage of the fund's fixed costs. In reality, expenses for many funds have gone only one direction: UP.
3) Taken as a whole, mutual fund returns meet the expectations of investors.
Not true. Indeed, a majority of funds don't even reach their benchmark index .
When looking at mutual funds, apply these four "reality checks" to ensure you understand what you're getting into. Here are some of the fund characteristics you should scrutinize:
1) The fund manager's investment strategy and whether or not it is relevant to your investment needs.
The fund manager's investment strategy can be found in the fund's prospectus, usually on one of the first few pages. Make sure it's a strategy that you agree with and that serves your needs.
For example, if you're invested in a mutual fund for your retirement, the fund should be conservative and suitable for long-term investors.
2) The fund's expense ratio, also stated in the fund prospectus.
The fund's expense ratio is its annual operating expenses divided by its average annual net assets. An expense ratio is the percentage of your assets a fund claws back each year as payment for its services. Most analysts consider an expense ratio of 1% or less to be reasonable.
3) Fund performance over three different time periods: the past year, past five years, and since inception.
A manager might get lucky over a short time frame, but if you use longer yardsticks you'll be able to separate true talent from sheer luck.
4) Portfolio turnover, as stated in the prospectus.
Keep a special eye out for unnecessary turnover within the fund.
According to industry analysts, in recent years fund managers have racked up an all-fund average turnover of about 85%.
In fact, many funds have turnover ratios in excess of 100%. In other words, in the aggregate, managers sold all the shares that they owned at the beginning of the year and bought new ones.
This sort of intense trading exposes you to the twin enemies of investing profits: income taxes and trading expenses. Industry experts estimate that trading expenses sock investors for between 0.7% and 2.0% every year, and income taxes can eat up another 0.7% to 2.7%, depending on your particular tax bracket. Add up all of these hidden costs, and they can take a big bite from your potential gains.
According to some estimates, hidden expenses altogether generate an estimated all-in cost of 4.52% for a taxable investor or 3.52% for non-taxable accounts.
Take care to screen all funds for unreasonable turnover ratios. If you pinpoint a fund that sports a turnover rate of 50% or more, calculate whether its returns are higher than funds with lower turnover rates.
Keep in mind the time periods involved and whether these returns were consistent. If you take the time to look, you can find plenty of low turnover funds that won't rack up unnecessary costs and fees by "churning and burning" your holdings.
For further insights, consult the financial advisors at Charles Schwab, TD Ameritrade, or T. Rowe Price.
As 2016 looms on the horizon, what is Warren Buffett buying and selling today? For our free and detailed report on the Oracle of Omaha's latest investment choices, click here. Our report tells you exactly what Buffett is adding to Berkshire Hathaway and why.
John Persinos is editorial manager and investment analyst at Investing Daily. At the time of publication, the author held no positions in the stocks mentioned.