Tuesday, June 14, 2011

Easy steps to selecting a mutual fund

For a new investor, the selection of a mutual fund could seem particularly daunting. However behind all the jargon and complexity, lies a series of simple steps, which if followed with some common sense and research could lead to long term wealth creation.

1. Identify funds whose investment objectives match your asset allocation needs:

Just as you would buy a car or a laptop that fits your needs and budget, you should choose a mutual fund that meets your risk tolerance (need) and your risk capacity (budget) levels (i.e. has similar investment objectives as your own). Typical investment objectives of mutual funds include fixed income or equity, general equity or sector-focused, high risk or low risk, blue-chips or turnarounds, long-term or short-term liquidity focus. (Check the mutual funds tab for a quick overview on these different types)

2. Evaluate past performance, look for consistency:

Although, past performance is no guarantee for the future, it is a useful way of assessing how well or badly a fund has performed in comparison to its stated objectives and peer group. A good way to do this would be to identify the five best performing funds (within your selected investment objectives) over various long term periods, say 1 year, 3 years and 5 years. Shortlist funds that appear in the top 5 in each of these time horizons as they have thus demonstrated their ability to be not only good but also, consistent performers.

3. Diversify but don’t Over-diversify:

Don't just zero in on one mutual fund especially if it is a thematic fund (to avoid the risk of being overly dependent on any one fund). Pick two ideally and pick two diversified funds. Picking two diversified funds from two different fund houses would give you all the diversification that you need. But remember that if you start thinking that you need to diversify further and start shopping for more funds, you would end up diminishing your returns. Check out the article – ‘The Problem with (too much) Diversification’ to know about the problems with too much diversification.

4. Consider Fund Costs:

The cost of investing through a mutual fund is not insignificant and is important especially when it comes to fixed income funds. Management fees, annual expenses of the fund and sales loads can take away a significant portion of your returns. As a general rule, 1% towards management fees and 0.6% towards other annual expenses should be acceptable. Carefully examine load the fee a fund charges for getting in and out of the fund.

5. Invest, monitor and review:

Having made an investment in a mutual fund, you should monitor it to see whether its management and performance is in line with stated objectives and also whether its performance exceeds or lags your expectations. Unlike individual stocks and bonds, mutual fund reviews are required less frequently, once in a quarter should be sufficient. A review of the fund’s performance should be carried out with the objective of holding or selling your investment in the mutual fund. The article on the blog on ‘When should you redeem your Fund’ discusses this in more detail.
Investing in mutual funds is not just a decision but is more a process. It requires more of discipline in adhering to the process and a certain amount of simple research.

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