One of the best steps you can take as a new investor is to learn what you should avoid. Understanding the following concepts can help you avoid losing large amounts of money before you are knowledgeable about investing in mutual funds. For example, Morningstar—a company that does research on mutual funds—notes that the single biggest predictor of top-performing funds was not their own rating system of assigning stars but the fund’s fees. Lower fees tended to directly correlate with higher-performing funds. Index funds—funds that are structured around an index, such as the Standard & Poor’s 500 Index—generally have the lowest fees. Why do lower fee funds fare well over time? It’s because higher-fee funds typically take an actively managed approach, where the fund pays a team of analysts and a fund manager to try to pick the highest returning investments at that time. Because the fund has to pay the fund managers, the fees are higher. While it is possible for higher-fee funds to perform well, you have to decide whether the fees and risk of chasing the latest and greatest returns are worth it. The top performers one year can perform the following year, but generally speaking, this doesn’t usually happen. Market fluctuations, economic circumstances, and investor sentiment and interests cause investment returns to rise and fall. Lower-fee funds, as passively managed funds, do not fluctuate as wildly as the rest of the market because they are made up of investments that have proven to be more stable in their returns, and they are not continuously turning over assets in favor of “the next-greatest investment.” Actively managed funds are also less tax-efficient. Because these funds actively sell and buy investments, they generate more short-term capital gains—which are taxed as normal income—rather than long-term capital gains, which are taxed at a lower rate. If you find an actively managed fund you want, it might be best to own it in an IRA or other tax-deferred account where you won’t get hit by large short-term gain distributions each year. If the shares have lost value, you’ll be paying taxes for losing money, even though you received a distribution. You can avoid this by purchasing mutual funds in a non-retirement account, tax-managed fund, index fund, or exchange-traded funds (ETF). At the end of each year, you might also harvest losses by realizing a capital loss for tax reasons if you exchange one mutual fund for another. A well-diversified portfolio gives you exposure to large market capacity (large-cap) stocks, small market capacity stocks (small-cap) stocks, international large-cap stocks, international small-cap stocks, real estate stocks, emerging markets, and various types of bonds. Before you buy shares of a mutual fund, look at the ingredients. Does the fund own something different than other funds you own? If so, it may be a good addition to your portfolio. If you’re not sure what holdings are in the fund, seek professional guidance, or use a balanced fund or target-date fund, as these types of funds automatically spread your investment out over a diversified set of holdings. However, if that capital gain occurs in your tax-deferred retirement account, you don’t get to take advantage of the lower long-term capital gains tax rates. When you eventually withdraw from the tax-deferred retirement account, everything that comes out will be taxed at the same rate as earned income. To keep taxes as low as possible—sometimes referred to as keeping your investments tax-efficient—you can use a technique called “asset location.” This is the process of deciding how to tax-efficiently locate certain asset classes across tax-deferred accounts like IRAs and 401(k)s, tax-free (Roth) accounts, and taxable accounts (brokerage and mutual fund accounts). Bond funds might be best suited for tax-deferred retirement accounts and stock index funds for non-retirement accounts. Many of the most successful investors focus on their long-term goals by carefully defining how their investment story should end and by defining the role each investment plays in the story. Speculators run to the popular “best investments” rather than masterminding the plot for themselves. You should purchase your mutual funds when it is right for you and at the right price for your circumstances and goals. You might be able to time your purchases right, such as buying them at one of the lower points of a market downswing when prices should begin to rise. Good investments are not the ones that everyone is raving about—they are the investments that are good for your plan, experience, and long-term goals.
