“What is the best mutual fund?”

To financial advisors and experienced investors, it’s a silly question. But it’s one that I’ve been asked–very much in earnest–by young people on several occasions. (Actually, it’s usually more along the lines of “So, like…what’s the best mutual fund?”)

For the sake of any investors asking Google that very question, I thought it might be beneficial to take a few moments to provide an answer here. (My apologies to any readers looking for more sophisticated fare.)

It Depends on Your Goals

The most important thing to know when choosing investments–mutual funds or otherwise–is that what’s best for you isn’t necessarily what’s best for me. We have different goals, and we need different investments to meet them.

If you’re saving to buy a house in 3 years, the best mutual fund is one that’s unlikely to decline in value in any given year–even if that fund only provides a modest rate of growth. If, on the other hand, you’re saving for retirement 40 years from now, it’s OK to use a fund that declines in value from time to time as long as you have reason to believe it will earn a satisfactory long-term return.

Generally, the biggest factor in determining a fund’s long-term return as well as its year-to-year volatility is the fund’s asset allocation.

What’s Asset Allocation?

Asset allocation refers to how much of a fund’s portfolio is invested in each asset class (cash, bonds, U.S. stocks, international stocks, etc.). When saving for most goals, you’ll want a mix of asset classes. And rather than looking for “the best fund,” you’ll usually want to create a portfolio of a few different funds.

For the most part, the more volatile an asset class is, the higher its long-term returns have tended to be. As a result, if you’re saving for a short-term goal, you’ll want a portfolio made up primarily of funds that invest in low-volatility, low-expected return asset classes (cash, bonds). And if you’re saving for a long-term goal, you can afford to put more money into funds that invest in higher-volatility, higher-expected return asset classes (stocks).

Look for Low Costs

Studies have found that within a given category of funds (U.S. stock funds, for instance), costs are the best predictor of performance. The lower a fund’s expenses, the better it’s likely to perform. (Not exactly surprising, is it?) When examining a fund’s costs, there are two things to look for:

• A low expense ratio, and
• Low portfolio turnover.

Expense ratio is simply what it costs the fund company to run the fund, and portfolio turnover refers to how frequently the fund buys and sells investments within its portfolio. Because each transaction comes with a cost, higher portfolio turnover means higher costs–costs that aren’t included in the fund’s published expense ratio.

A fund’s expense ratio and portfolio turnover can be found by either reading the fund’s prospectus or by simply doing a Google search for the fund’s name.

Almost without exception, the funds with the lowest costs and lowest portfolio turnover are index funds–mutual funds that simply seek to match the market’s return rather than attempting (and failing) to beat it.

“The Best Mutual Fund (Portfolio)”

In short, for most investors, the answer to “What is the best mutual fund?” is really “A portfolio of low-cost index funds with an appropriate asset allocation for your goals.”

Thrilling, isn’t it?

People like to simplify. We like easy-to-follow guidelines and easy-to-implement instructions. That’s why rules of thumb are so popular. The two investing rules of thumb that I see quoted most frequently are to:

1. Set your bond allocation (as a percentage of your portfolio) equal to your age, and
2. Save and invest 10% of your income.

I really like the first one. I think it’s quite helpful. The second one, however, is a mess.

“Age in Bonds”

Why is the “age in bonds” rule helpful? Because asset allocation comes down to just two variables:

• Your expected holding period, and
• Your tolerance for volatility.

The rule accounts for one of those variables (holding period). So all you need to do is adjust the rule’s prescription based on your volatility tolerance. No problem.

“Invest 10% of Your Income”

In contrast, the question of how much of your income to invest each year involves many more variables than the question of asset allocation. Specifically, it depends upon:

• The age at which you started investing,
• The age at which you plan to retire,
• Whether or not you plan to continue working part-time,
• Whether or not you expect Social Security to pay out at the rate it’s currently promising,
• Whether or not you’ll have any pension income,
• Whether or not you’ll own your home, and
• What you plan to do in retirement. (Do you plan to travel the world? Or mostly just hang out in your hometown with your grandkids?)

The “invest 10% of your income” rule doesn’t account for a single one of those variables! If you ask me, that’s a dangerous oversimplification.

When a Rule of Thumb Doesn’t Cut It

Sometimes there’s really no shortcut. Sometimes you actually have to do the math (or find an advisor or online calculator to do it for you).

That’s the case when determining how much you’ll need to invest each month. That’s the case when determining how much life insurance you need. That’s the case when determining whether you should form an S-corp or C-corp for your business.

You get the idea. When it comes to your finances, rules of thumb can be dangerous. Even if there is a rule that pertains to the question you’re seeking to answer, it’s best to learn the reasoning behind the rule so that you can decide for yourself whether or not you should follow it.