10/8/2012 6:21 PM ET|
5 big mistakes fund investors make
Common miscues prevent investors from enjoying the relative simplicity and safety of mutual funds. Here’s how to avoid them.
So, more than three years into a bull market, you think you've got this investing game down, right? You know, 6% of your paycheck goes right into the 401k plan's mutual funds. Rinse and repeat.
Well, yes. Investing in mutual funds can be an easy, inexpensive and low-risk way for investors to play the market.
But despite the relative simplicity, mutual-fund investors are still making some costly mistakes that eat into their returns and may put their portfolios at risk. The Wall Street Journal talked to financial advisers and accountants to learn some common fund traps that catch unwary investors.
1. Not knowing what you own
San Diego certified financial planner Andrew Russell recalls a client who thought her 401k was well diversified. Back around 1999, the client invested half of her retirement savings in a technology fund and the other half in a fund indexed to the Standard & Poor's 500 Index ($INX). What the client didn't realize was that roughly 30% of the index fund was exposed to the tech sector, putting her entire tech exposure at roughly 65%.
By the time she sought Russell's help three years later, her net worth had shrunk by 45%.
To avoid unwittingly doubling down on a stock or getting overexposed to a certain asset class, investors should know the investment style and holdings of their funds, says Cal Brown, a McLean, Va., certified financial planner.
Carefully reading a fund's prospectus is a good way to learn about a fund, he says. To avoid overlap, investors also should be sure to consider the allocation of their entire portfolio before purchasing a new fund, he says.
"Take a holistic view of your investments," Brown says.
2. Chasing performance
While it may be tempting to buy the "hot fund" you heard about at a cocktail party or on TV, buying a fund solely based on past performance is "generally a bad idea," says Roger Wohlner, a certified financial planner in Arlington Heights, Ill.
The cyclical nature of markets is another reason not to chase returns, he says. A fund might do well because it invests in a narrow niche that's hot now, for example, but should things change, that might cause the fund to underperform in the future, Wohlner says.
In the case of an actively managed fund, the fund manager who compiled the fund's track record may have left.
This isn't always a "deal killer," Wohlner says, but investors need to know if the fund's performance was based on the individual in charge or on an investment process that's been institutionalized at the fund company.
3. Underestimating the impact of fees
Investors who are often more concerned with macro factors, such as the state of the U.S. economy or the growth in certain emerging markets, may not pay close attention to fees when selecting a mutual fund. But that's a mistake, as fees can take a big bite out of a fund's return over time.
For example, a $2,500-a-year investment in the S&P 500 from Oct. 1, 1982, to Sept. 30, 2012, would be worth more than $400,000. But figure in a mutual fund's yearly fee of 1.5% and the total drops to below $300,000.
"People often underestimate the effect of compounding," says Russel Kinnel, the director of mutual fund research at Morningstar.
Fees can especially eat into the returns of many bonds funds, which have experienced historically low yields, he says.
A fund's prospectus must list the fund's expense ratio. Investors can use websites such as Morningstar to see how a fund's expenses compare to other funds in the same category.
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