AVOIDING THE PITFALLS OF MUTUAL FUND INVESTING

For as long as mutual funds have existed, investors have wrestled with how best to select option from a confusing array of almost limitless choices. Over time, one lesson has become quite clear—making the “right” choice often requires navigating around some common pitfalls.

Pitfall # 1: Unrealistic Expectations
We would all like to find a “fool-proof” mutual fund—one that goes up even when the market goes down, a fund that provides a 20% return with very low risk, or one that generates consistently good returns year after year. Finding such a fund is about as likely as finding the pot of gold at the end of the rainbow. Realistic mutual fund investors must accept the fact that no fund is immune to the basic forces of the capital markets. The fact is that financial markets move in cycles that cause investment rates of return to both rise and fall. The direction, frequency and intensity of these market fluctuations depend upon a wide range of market and economic factors and the volatility of a particular investment.

Pitfall #2: A Focus on Past Performance
Many investors buy a mutual fund because it has been a top performer over the last year or the last quarter. A closer look at the numbers, however, indicates that there is little consistency among front runners over time. In fact, a study made by Lipper Analytical Services, a mutual fund performance tracker, shows that a fund ranked among the top ten in one year has only a fifty-fifty chance of appearing in the top two quartiles the next year.

Pitfall #3: Sales Load Phobia
Mutual funds that are sold by a broker or other registered financial professional charge a fee— generally called a sales "load"—to cover sales and distribution costs. It is only prudent for an investor to consider the effects of a sales load as part of their overall evaluation of a fund. However, the investor who completely ignores any mutual fund that carries a sales load not only reduces the number of available investment choices, but may also forgo the benefits to be derived from dealing directly with a professional financial advisor. Many studies have shown that the impact of a sales load on the overall return of a mutual fund is greatly diminished over time. In addition to asking, “Does this fund charge a sales fee?” an investor should also ask “Does this fund meet my individual needs?” and “Could I benefit from the advice of a trained investment professional?”

Pitfall #4: Yield vs. Total Return Confusion
Current yield, which is often cited in mutual fund advertising, is not the best way to determine the long-term benefits of any mutual fund. Current yield simply measures the income produced by the fund produced during a specific period. Total return, on the other hand, is a measure of a fund’s net performance over a specific period, reflecting the combined effect of not only income, but also dividends and capital gains or losses. While current yield is always positive, total return can be either positive or negative. As a result, return is the better measure to use to evaluate the historical performance of a mutual fund.

Pitfall #5: Waiting for the Best Time to Invest
It’s usually time, not timing, that allows an investment to appreciate. So-called “market timers”—those who try to invest only at the most opportune moments—run the risk of being out of the market during periods when it achieves the best results. As the chart below illustrates that the investor who stays invested in the market (represented here by the S&P 500) is most likely to get better results than investors who wait for the “best time.”