Most of us have a huge portion of our assets invested via mutual funds, so it’s important to know how to choose them. Unfortunately, there’s a lot of misinformation out there. Keep the following facts in mind, and you should do just fine.
Past Performance
1. Past performance is not indicative of future results. The disclaimer you see everywhere isn’t just cover-your-ass legal mumbo jumbo. It’s based on real studies.
Costs Matter.
2. Sales loads are money down the drain.
3. “No-load” does not mean “free.” No mutual fund is free. Ever.
4. Always look for a low expense ratio. Within a given category of funds (government bond funds, for instance), expenses have been shown to be the best predictor of future results.
5. Portfolio turnover leads to expenses not included in the expense ratio. Always look for low turnover.
6. Without fail, the lowest-cost funds are index funds or ETFs. (Which is cheaper for you depends upon your situation.)
Asset Allocation
7. Asset allocation is the single biggest factor in determining the performance of your portfolio. Invest in a mutual fund because its asset allocation fits your needs, not because of its past performance.
8. Beware of style drift. You cannot control your asset allocation if you don’t know the asset allocation of the funds you own.
9. Before investing in a target date fund, check its asset allocation and glide path. Within funds of a given date (Retirement 2020, for example), the asset allocation can vary significantly between fund companies.
Taxes
10. Stock funds are naturally more tax-efficient than bond funds. Given the choice, tax-shelter your bond funds (via an IRA, for instance) before tax-sheltering your stock funds.
11. If you’re investing in a taxable account, portfolio turnover becomes twice as important because it leads to higher taxes as well as higher costs.
Get Moving!
There’s no need to make this into something more complicated than it really is:
- Look for low-cost, low-turnover funds that fit your asset allocation needs, then
- Start putting money into them.
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{ 14 comments… read them below or add one }
This is a great list, Mike. I love how you’re able to break down these investing topics that seem so stuffy and intimidating and make them really easy to understand. I wish I’d had this and some of your other articles back when I started in financial writing!
“Given the choice, tax-shelter your bond funds (via an IRA, for instance) before tax-sheltering your stock funds.”
I see the argument behind this, but I’m not convinced. I expect that (on average) my stock funds would grow more than bond funds. If my stock funds are tax-sheltered, wouldn’t that mean that I have a larger amount of earnings on which I don’t have to pay taxes? I’d be interested in seeing a numbers comparison.
I’d have to go w/Erica on this one too.
I’ve heard this argument and from an asset allocation standpoint….it does make sense (although you know how I feel about asset allocation).
Retirement money is our longest term money. Go for the growth baby!
Erica and Neal: I’d recommend checking out the papers/studies referenced in this thread from the Bogleheads Forum.
It’s easy to think that your taxable money is your shorter-term money, and your IRA is your longer-term money. So you’d want your IRA in stocks and your taxable in fixed income.
However, that overlooks the fact that if you need to liquidate something, you can simply sell stocks out of your taxable, and buy comparable–though not “substantially identical”–holdings in your IRA (after selling some fixed income in your IRA to raise the cash). End result: You raised cash to pay for whatever expense it was, and you did it without having to decrease your stock allocation.
Tax-sheltering your tax-efficient assets rather than tax-inefficient assets is just throwing away money.
It seems to me that it would be simpler just to invest in a broad index fund and set your own allocation rather than trying to find a mutual fund that goes with an allocation of which you approve. Non-index mutual funds seem to me to be a product in search of a purpose (although I can think of a few rare exceptions to the general rule).
Rob
Mike,
Are bond ETFs a tax efficient alternative to bond mutual funds? If so couldn’t you have you cake- tax efficiency and eat it too no need to put bonds in an IRA?
-Rick
Good question, Rick.
The income from a bond ETF, however, will still be taxed at ordinary income tax rates. It’s only the capital appreciation that would be particularly tax-efficient.
Mike,
Thanks for the answer – I feared it was too good to be true.
-Rick
I’m with Mike on the sheltering the income producing stuff like bonds in an IRA.
Not having to recognize capital appreciation until it is realized makes the appreciation of stock index funds essentially tax deferred. I suppose if someone is using higher turnover, actively managed funds, they might be better of in an IRA.
Correct me if I am wrong, but doesn’t the lower long term capital gains tax rate sunset in 2010, unless congress extends them? If so, then for younger investors who are investing for loooong term tax sheltering bond or stock funds shouldn’t make much difference.
Mike, on another note, what are your thoughts on the new No Commission ETFs from Schwab?
GoYanks: My understanding is that as it stands right now, yes the current lower tax rates for LTCGs and dividends will expire at the end of 2010. After that, dividends will be taxed as ordinary income, and LTCGs will be taxed at a max rate of 20%.
So yes, the benefits gained by tax-sheltering bonds relative to stocks will decrease. Whether it continues to make sense would then depend upon how an investor’s tax bracket compares to the LTCG tax rate, and what portion of total stock market return you expect to come from capital appreciation rather than dividends.
Regarding Schwab’s new no-commission ETFs, I haven’t looked into them too heavily yet. But the ERs are nice and low, and you can’t argue with a $0 commission. Also, am I missing something, or is there no corresponding no-commission bond ETF?
Good points Mike. I’ve become obsessed with low expense ratios. I even invested directly in Canadian REITs because the 0.55% MER was too expensive in my view. Plus, 4 REITs gave me about 60% of the weighting of that index.
That one aside, I love low cost index funds and ETFs, won’t touch an active mutual fund ever again!
Mike, You are not missing anything. There is no bonds ETF. Only 8 equity ETFs are planned.
i am kind of against mutual funds because of overdiversification that i fear will eat away at my returns. But since i want to invest in precious metals, investor gurus say that the best way is to do so through mutual funds to avoid too many fees and storage costs. so these pointers will come in handy