To compare mutual funds. . . what do you consider? Are mutual fund ratings enough? Are historical rates of return enough? How do you choose?
If someone else is doing the choosing for you. . . how do they choose? You do know. . . don't you?
With so many different mutual funds available. . . the real question is. . . how can the list be reduced to a reasonable number of quality funds from which to make your final choices?
Most people compare mutual funds based on just one criterion. . . past performance.
The thought is that if a fund has done well in the past. . . then it should do well in the future.
And, how do most investors learn whether a fund has done well in the past? They often rely on some third party ratings system or list to guide them to the best mutual funds.
One of the most popular rating systems is the Star Ratings provided by Morningstar.
Studies have shown that nearly all of the new money invested in mutual funds goes into 4-star and 5-star funds. At the same time net withdrawals are typically incurred by all 3-star, 2-star and 1-star funds.
If you use an investment advisor. . . he likely recommends 4-star and 5-star funds to you. He knows that if he doesn't. . . you may go to another advisor who does.
So, if most everyone uses the Morningstar rating system to compare mutual funds. . . the question is. . .
Does it work?
Will you experience better performance by picking 4-star and 5-star funds? Is your investment risk reduced by only choosing 4 and 5-star funds?
The answer is. . . not necessarily.
A mutual fund's performance changes constantly because its environment is changing constantly. Hence, the ratings change constantly. A five star fund today may be a two star fund in the very near future.
To effectively compare mutual funds, you need a methodology that is broader, and more logical, than just chasing after the currently highest rated funds.
That said. . . here is the basis of a very simple yet effective approach that logically compares similar types of mutual funds.
Did you catch that? I said similar types of mutual funds. In other words don't try to compare a “growth" fund with an “income" fund. That's like comparing apples to oranges. Comparisons can only be made among similarly classified funds. Compare funds only against their peers.
Fund comparison in the following five major areas will provide you enough information to choose the best mutual funds for your portfolio allocation.
- Relative Performance
- Standard Deviation
There is no need to add excessive layers of complexity to the decision making process. Too much complexity can overpower you, delay you, and often cause you to make the wrong choices.
The best approach is neither too simplistic nor too complex.
Simplicity leads to understanding and understanding leads to good choices and peace of mind.
"Because It Matters". . . Jim
For a more detailed discussion about how to evaluate and compare mutual funds. . . go to http://www.financial-choices-matter.com/compare-mutual-funds.html
The http://www.financial-choices-matter.com/ website is dedicated to helping people understand what really matters and how to make smart personal financial choices.