With thousands of mutual funds to choose from, picking the “right one” can be a daunting task. Most investors know not to fall for a short term hot streak – one or two years isn’t a long enough track record to show superior skill of the management team over sheer luck – but where should you start?

Step 1.  Figure out what you really need.

To be a successful investor, be it in mutual funds, hedge funds or whatever, you need to determine what your objectives really are and what asset allocation you’ll need to meet those objectives. And sorry to tell you this, but “to get rich” is not an objective.

Objective.

For your objective to be meaningful and achievable, it needs to be specific. If you can determine exact numbers, then you’re off to a great start. But even if the numbers are not exact or may even be unknowable, you can still use that as an objective.

For example, if your objective is to have $25,000 in 5 – 7 years for a new car, then you have a defined timeframe, and target amount. From that you can then figure out how much you can invest over that time  frame and see how much return on your money you’ll need to get there. (There are calculators for this kind of thing).

Even if your objective is a bit less knowable, say saving for retirement, you can use ballpark figures for determine the “best guess” for what you’ll need 15, 20, even 30 years out from today. The key is knowing that this is just a guess, based on current trends. In the case of retirement planning you reevaluate your goals and assumptions on a regular basis, every 5 -10 years for example.

The Takeaway. The point to take away from all of this is that your objective (amount and time frame) will be a key component in determining your risk level and asset allocation. You can (and should) invest more heavily in stocks for retirement which is decades away than for the objective that’s 5-7 years away.

Asset Allocation.

Put simply, an asset allocation is which types of investments you choose to put your money in, and in what proportions.

Different types, or classes of investments carry with them different levels of risk and average return. Bonds, for instance, are typically less risky than stocks, though that is a generalization since there are subclasses of stocks and bonds that can be very similar in terms of risk and reward.

Key points of concern are correlation (how much one investment be behaves like another), volatility, and risk.

The Takeaway. Some studies have shown that asset allocation alone is responsible for up to 90% of your total return, so be sure to study up on this stage and know what you’re doing.

Step 2. Picking mutual funds.

Since this article is about mutual funds, I will focus on that aspect of an asset allocation. But remember – if your investment goals are short term, then mutual funds may not be right for you.

Searching for a mutual fund.

If you have an idea of what type of fund you’re looking for, say a small cap stock fund, and you’d like to see what mutual funds fit that category, you can use Kiplinger’s Fund Finder. This tool allows you to select broad categories (like small cap stock funds) and narrow the results by a host of criteria, including:

• 1,3 or 5 year return.
• Morningstar rating.
• Return in a down market (i.e. worst loss).
• Expense ratio.
• Turnover ratio.
• Length of time the current management team has been in place.

And much more. It’s very handy for gathering a list of mutual funds to choose from, but you still need to do some comparison work, but more on that in a minute.

Gathering information on a specific fund.

Once you have a list of funds, or maybe you’re looking for details about a specific fund in your 401(k), you can use FINRA’s Fund Analyzer to get the specifics about a fund.

These results include average return of a given investment amount over a specified period of time, and the total expenses. It also provides a breakdown of the allocation within the fund, investment style of the fund (i.e. growth, vs value, etc..) the Morningstar rating and much more.

Some thoughts on past performance not guaranteeing future results…

By now I’m sure you’ve heard that familiar phrase of investment marketing: “Past performance is not a guarantee of future return”, or something similar. It’s usually uttered as a means of protecting themselves from costly liability in court situations, but it is also a significant thing to bear in mind when picking a fund.

The thing to remember is that just because a fund had a rip-roaring 3 years does not mean it’s going to continue to rip and roar its way up the charts for the next 3 years. Maybe it was a small cap stock fund and the economy has just come out of a recession. If that’s the case, then you can expect those returns to level off a bit as the economic cycle matures and investors seek blue chip companies over small cap.

But long term performance can be a good indicator of a fund’s quality. Look for good for funds with good performance over a 5-10 year period.

Some thoughts on volatility…

Volatility is simple a measure of how much the fund’s price jumps around; it’s a measure of how much of a roller coaster ride the fund is. The lower the volatility, the smoother the ride, but not necessarily the higher return. The thing to keep in mind with volatility is that it doesn’t matter how bumpy the ride is if you don’t need the money for another 20 years. In other words, volatility is less important for long term investments.

Some thoughts on Managers…

Things you’ll want to know about the fund’s manager include:

• Does the manager admit mistakes?
• Does the manager respect the investors?
• Does the manager sound too greedy?
• Does the manager know what he’s talking about?
• Is the manager personally invested in the fund? (that’s a good thing)
• Does the manager stick to his stated strategy?

One last thought about fees…

Not all funds are created equal, and one of the biggest defining characteristics of a fund may be its fees. All other things being equally, higher fee funds will perform worse than lower fee funds. But things are rarely equally and the thing you need to find out is whether the higher fee fund significantly outperforms its peers over an extended period. In other words, is it worth the extra money? If it’s just doing the same as an index fund, it’s not worth the money.

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According to Burton G. Malkiel, a Princeton economics professor, and Charles D. Ellis, author of ‘Winning the Loser’s Game,’ the only difference between them and Warren Buffet is that Warren Buffet hasn’t made these mistakes.

Of course, it’s more than that but since you and I (or Malkiel and Ellis for that matter) don’t have any chance of acquiring Buffet’s DNA, we’ll focus on this list – in the spirit of accepting what cannot be change, and having the courage to change the things that can be changed.

6 investing mistakes to avoid:

• Overconfidence
• Following the Herd
• Timing the Market
• Assuming More Control Than You Have
• Paying Too Much in Fees
• Trusting Stockbrokers

By way of proof of Buffet’s unique investment acumen and, more importantly, his ability to focus and remain true to his core investment philosophy, Malkiel and Ellis cite two prime cases when Buffet was tested by the markets and prevailing “common knowledge”.

Case number One was when Buffett avoided the dot com bust of 2000, simply because tech stocks fit neither his investment style, or his philosophy. But he held firm to his approach, even when it was called outdated by the rest of the investment world. As a result, his portfolio avoided much of the carnage that befell those more “enlightened” investors.

Case number two was when Buffett avoided mortgage-backed securities and derivatives in 2005-2006, because he found them too complex and “opaque”. As a result, he avoided the worst of the damage caused by the economic collapse that ensued.

In regards to the list above, you can see how Buffett’s sense of humility, and discipline have kept him from making many of the mistakes out lined in more detail in Malkiel and Ellis’ original article.

Burton G. Malkiel, Princeton economics professor and author of ‘A Random Walk Down Wall Street,’ and Charles D. Ellis, author of ‘Winning the Loser’s Game,’ have teamed up to write ‘The Elements of Investing.’

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The Mutual Fund Monday post this week is a highlight of a recent post from Kyle over at Amateur Asset Allocator .

Millions of Americans own mutual funds in their 401(k) plans, and many others own them in their IRA’s or even in a taxable, non-retirement account. But many people don’t have any idea of how to really compare the funds that are available to them. Here’s a hint – it goes beyond simply finding the highest return for a given time period (Ex: 1, 3,5 or ten years).

Kyle’s post is a great explanation of how to compare mutual funds, and their associated indexes. He explains how to compare apples to apples, and not apple to oranges (all mutual funds are not created equal!). He also explains the basics of knowing which index to compare a fund’s performance to, and why. And lastly, he explains how to compare two mutual funds – and more important, how not to.

So what are you waiting for? Head on over and give him a read.

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Here’s a list of some investing insight I’ve learned over the years that I hope will help accelerate the beginning investor’s road to wealth.

1. Don’t go all in at once.

If you have a lump sum of money to invest and you are doing so when the market is going down, don’t just use it all at once to buy shares. Instead, split that lump sum into 3rds and buy at periodic intervals as the market goes down. The idea is that you simply cannot time the market effectively, so don’t bother.

Instead, you’re dollar cost averaging on the way down and spreading your money out like scatter shot instead of a single bullet. By doing so, you will improve the chances of hitting near the lows with at least some of your purchases.

2. Don’t be paralyzed by taxes.

Often times, individual investors hold on to a winning stock because they don’t want to pay the taxes on it, only to have waited too long and find they rode the stock back down to loser territory.

It’s an understandable course of action, after all when an activity is taxed, people do that activity less than when it is not taxed. But you have to get past that and realize that even at a 42% tax rate, you still have a 58% profit.

But let’s be clear – I’m not saying you could ignore taxes, only that you shouldn’t allow their implication to paralyze you into inaction.

Taxes should be an important part of your investment planning. For example, you want to be aware of the kinds of assets you hold so you don’t keep tax free, municipal bonds in a tax deferred account.

3. Broken stocks are OK, broken companies are not.

A stock’s price is a function of the quality and value of the underlying company, over the long term. This means that if you are looking to hold onto a stock for the long term, say 5-7 years, you should avoid stocks of broken companies and instead look for stocks of good quality companies that have suffered a temporary decline in stock price. Eventually the market will recognize the superior quality of the company and reward the stock price. Conversely, stocks of broken companies become broken stocks over time. An example of this might be Johnson & Johnson in the fall of 2008. The stock price suffered because the market as a whole crashed, not because the company was in poor shape. GM stock on the other hand suffered because the company was bankrupt and has no upside potential.

4. No one ever got rich panicking.

The key to success is simple to understand, difficult to practice – have a plan. You will never be a successful investor if you “just wing it”, “play by ear” or perform in a host of similar colloquial cliches.

Instead, you need to have a plan for when to buy and when to sell each and every stock you hold. Once you have your plan, use Stop Order and Limit Order to take the emotion out of your buying and selling.

5. Diversification is essential.

There have been a lot of pundits pointing out that diversification didn’t help in the 2008-2009 crash, but that while that is true, it’s not as important as it may at first seem .

Firstly, the 2008-2009 crash is not the norm and you’re far more likely to encounter situations where diversification would protect you than you are to experience another such crash.

Secondly, the only things safe in the 2008-2009 crash were cash and (maybe) commodities. If you want to prepare for a 2008-2009 style crash you should diversify some of your holdings into these asset types. But if you held most of your portfolio in them most of the time, you would lose in the long term.

6. Buy and hold is not “set it and forget it”.

Buy and hold investing is great for retirement savings, but even then you need to pay attention. Too many people mistake “Buy and Hold” for some similar sounding marketing gimmick from Ron Popiel.

“Set it and forget it” in the investing world is simply neglect, and it will catch up with you sooner or later.

Instead, you should periodically create a list of your holdings and rank them , that way you will have a course of action and always know where your holdings stand regarding buy, sell or hold.

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401(k) plans can be a great way to save for retirement and let your savings grow tax-free. But the plans are chosen by employers and managed by 3rd parties and don’t always have the best options. IRAs give you the entire universe of investments to choose from, but most employers offer a free match on a percentage of contributions to the 401(k) plans by the employee. So what’s an employee to do when the 401(k) plan has lousy investment options?

Here are 5 options, though there may be more.

1. Be an index hugger.

If your 401(k) plan offers index funds, then you can still get broad-based exposure and diversification at a low cost. You won’t be beating the market, but you won’t under perform the market either.

2. Take the best and move on.

If your 401(k) plan has one or two excellent funds and a dozen other mediocre funds, take the one or two and skip the others. This may seem like you’re not properly diversifying, but you should consider your entire collection of assets when diversifying, not just a single account.

For example, say your 401(k) plan has one excellent blue chip stock fund, and an equally excellent small cap stock fund, but the bond funds are lousy. You should invest in the stock funds offered by your 401(k) and invest the overall bond allocation in some other account, like an IRA account or maybe your spouse’s 401(k). Each individual account will be non-diversified, but when taken together your total assets will be diversified.

3. Look into the “window”.

More and more large employers are offering 401(k) plans with a “brokerage window” or “self-directed accounts.” These options allow the employee access to hundreds or thousands of other mutual funds, ETF’s and even individual stocks that aren’t part of the standard 401(k) plans options.

Be sure to investigate the details and learn about any additional fees or transaction costs that may be associated with the use of the “window”. There may be additional work on your end as well, since this option is unlikely to be available for automatic contributions like the standard 401(k) options. You may need to fill out additional paperwork or make other such declarations.

4. Talk to HR.

If you think your 401(k) plan stinks and you can get other coworkers to join you, you can petition your HR department to change the plan, or go with a new plan provider altogether. The more employees unhappy with the status quo, the more likely you can get your employer to change things.

5. Check out other options.

If all else fails, you can always go it alone with an IRA account. But if you get a company match on your contributions, then pick the best fund that’s offered and contribute at least enough to get the full company match and put the rest in an IRA. There’s no point in passing up free money, no matter how lousy the fund options are.

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There was a time when only the wealthy and well connected could invest in the stock market. Then IRAs and 401(k) plans ushered in a new era of the “common man” investor. Flash forward a bit more, to the Internet age, and we have a grand democratization of the stock market.

Not too long ago, you had to be one of the aristocracy to have access to what the power elite could dabble in: options, shorts, foreign exchange (forex), margin, commodities futures, to name a few.

But thanks to the Internet and the information age bringing investing to the masses, all that has changed. You can buy stock options through dozens of online brokerages like TD Ameritrade, Charles Schwab and ShareBuilder. Similar availability exists with foreign exchange markets, shorts and commodities futures.

When retail investors began purchasing shares in mutual funds in the 1970s, Forbes magazine was able to print the returns and expenses of every fund available. But now there are over 9,000 mutual funds on the market. When ETFs were first available in the 1990s, there were a handful and most were simple index tracking funds. Now there are over 700, many with elaborate weighting algorithms and some are straight actively managed funds.

But just because you can make use of these tools and techniques, doesn’t mean you should.

When it comes to saving for retirement, college or building your estate to pass on to future heirs, the tried and true stocks, bonds and mutual funds (and index ETFs) work just fine. The key isn’t how fancy or esoteric your investment vehicle is, but how you allocate your assets.

Take trading on margin for example. Margin is simply investing with borrowed money, usually from the brokerage. You borrow the money at a specified interest rate, and agree to pay it back with interest – hopefully once you’ve earned more from your investments than the cost to borrow. Margin amplifies returns, but it also magnifies losses, and you could end up owing more than you have. For this reason, it’s best left alone by the individual investor.

Another needlessly risky technique is shorting. Shorting is a bet that an asset will go down in value. At least in terms of individual stock, shorting puts the investor at odds with management. Knowing a particular stock is a dog, and not worth its trading price is one thing, but timing when the market will realize this is quite another.

But the real reason short selling is so risky is that you have virtually limitless amounts to lose. Consider this:

“You short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold.

Your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares and you have a profit of $3,000 ($13,500 – $10,500 = $3,000). I have ignored commissions and so on to keep the math simple.”

Sounds great, you pocket a quick and easy 3k in profit. But here’s what happens when you guess wrong:

” You short 300 shares at $35 for $13,500. However, instead of falling like all reason and logic suggests, the stock rises and rises fast.

Before you know it, the stock is at $55 per share. You get a call from your broker, who is getting nervous. Your account for short selling is a margin account and if the stock goes too high, you will have to deposit more money or cover the short by buying the stock.

You decide to cut your loses and cover the short by buying the stock at $55 per share for $16,500. Since you only have $13,500 in your account, you have to come up with another $3,000 out of your pocket to make things right. You suffer a $3,000 loss. “

But what if the stock rockets past $55 a share. A stock can only lose so much money, and most stable companies don’t go to 0. But a share price can rise a long way before it starts to turn, and that can add up to big losses when you’re short.

For these reasons and more, you’re probably better off sticking to the simpler approach of The Simple 7 or the super simple One Minute Portfolio.

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It seems counter intuitive, that choosing the wrong kind of savings account for your child’s college fund could actually cost your child more, but that’s the world we live in – make the wrong choice, and your child may lose thousands of dollars in financial aid come enrollment time.

According to Robert Helgeson, director of financial aid for Valparaiso University in Indiana:

“If a parent has $100,000 in assets, the government is going to expect them to contribute $6,000 of it to education. If a student has $100,000 in assets, the government will expect $20,000.”

So, you can see where you stash your money is just as important as how much you stash.

According to the U.S. Department of Education, the student can have up to $3,000 saved in a checking or savings account in their name without losing any financial aid, but every dollar above that takes 20 cents away from any federally funded scholarships and grants junior would have been eligible for. After that, the money would be subtracted from federally funded loans.

Here are 3 places to safely shield your college savings without causing the loss of any aid.

529 college plans

This is perhaps the most popular method among younger parents. 529 plans are much like 401(k) or IRA plans, except you’re saving money for college instead of retirement. But the idea is the same. You contribute money to the plan, set your desired allocations for the money (choose between stock, bond and money market funds), and the money grows tax free – provided it is only used for education related expenses. An added perk to many plans is that if you live in the state that offers the plan, you can often deduct your contributions from your state income tax bill. 529 plans offer flexibility in determining the “owner” of the plan as well, since the parent can control who the beneficiary is. This means that if junior decides he’s going to the #1 party school, and he doesn’t really know what for, you can keep the funds from him until he gets his act straight.

529 plans do carry some restriction though. For example, the funds can only be withdrawn tax-free for educational expenses. Also, the funds available for allocation are limited.

UGMA and UTMA Custodial Accounts for Minors

The Uniform Transfers to Minors Act (or Uniform Gifts to Minors Act) provide a alternative methods of transferring ownership of cash and other financial assets to children who are too young to handle such assets, that may be simpler, cheaper and faster than a trust. Before the 529 plan became ubiquitous, the UGMA and UTMA accounts were often used as a means for parents and grandparents to provide savings for children and grandchildren.

According to the IRS, the first $950 in gains is tax-free, the second $950 is taxed at the child’s income tax rate and the remainder is taxed at the parent’s income tax rate. As you can see, the tax benefits are not nearly as robust as they are in a 529 plan, but the UGMA and UTMA custodial accounts place no restrictions on what the money can be used for. This can be good or bad, depending on your situation. For example, the child becomes the sole beneficiary of the assets in the account at age 18 or 21 (depending on the state you live in), so there’s no way to make sure junior spends that money on college and not a trip across Europe.

Roth IRA

The Roth IRA is an Individual Retirement Account in which you pay taxes on the contributions, but not on the withdrawals – ever. So what’s in doing in a list of college savings accounts? I’m glad you asked.

Once the child has an earned income, he can open a Roth IRA. Once the child turns 18, he has sole control of the account, so here again the parents lose control over what the money is spent on. One important restriction on the Roth is that withdrawals can only be made on the earnings after the child turns 59½. BUT, contributions can be withdrawn tax free at any time. So, if you’re looking at stashing a large sum of money for college, a Roth is a great way to shield the money from financial aid formulas and give the child a head start on retirement savings, since any money earned after the contributions will continue to grow tax free since it can’t be withdrawn until the child turns 59½.

Conclusion.

It seems that the custodial account is really a dinosaur when it comes to savings vehicles for children, but the 529 and Roth can be incredibly beneficial. If you’re a young family, with only a modest amount of money available to contribute on a steady basis, the 529 plan is probably the best choice. But if you come into an inheritance, or the grandparents want to make a one-time gift and you don’t mind the possibility of your child being able to use the money for something other than college, a Roth IRA is definitely worth a look.

Photo © by alancleaver_2000

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Retirement is a time of great financial uncertainty and worry for many people. The common thinking is that you spend less in retirement than you did when you were working. Once you’ve retired, you no longer have the expenses associated with a commute, eating lunch out, new suits and career upkeep like training and so forth. But the reality is that many retirees spend more in retirement, at least in the first few years. New retirees like to catch up on home maintenance and feed their pent up thirst for travel. And don’t even get me started on greens fees!

So what’s a prospective retiree to do. Put your retirement plan to the test of course. A dry run in the years leading up to your target retirement date can help you see what kind of lifestyle you’re actually in for while you still have time to adjust.

Here’s a simple, 3 step approach:

1. Track spending. Get an idea of what your expenses are that will carry over into retirement. You want to track your cable bill but not what you spend on lunch with the guys from work or bridge tolls, for example.

2. Create a budget and stick to it for a year or two. Once you have an idea of what you think will be your expenses in retirement, create a budget and limit yourself to living on that amount.

3. Invest the money you’re not using into your retirement account. Take the difference between your budgeted expenses and your income and invest or stash it in a savings account. This will let you see what retirement will be like while increasing your retirement savings – a win-win!

The end result of this process is an emotional preparation as well as financial test drive. You will see if you really are ready to retire or not. If you are, then you’ve gotten some practice and some extra savings. If you’re not, then you’ve got some work to do. Get your financial house in order, minimize expenses, maximize savings and investigate other options like working longer, or part time in the early years of retirement. Whatever the outcome, you want to become aware of any problems before you’re on that fixed income and have less options.

Photo © carlos170691 (is busy with his assignment)

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To Mary Beth Franklin, editor of Kiplinger’s magazine, it also suggests a new way to view near retirement and post-retirement investing. It puts emphasis on what she calls “Reliability of Income”. Mary Beth suggests that retirees divide their assets into 3 buckets:

Bucket 1:

25% in laddered CDs or short-term, immediate payout annuities. This will generate safe income for the 1st 5 years.

Bucket 2:

50% in bonds and broad based stock market index funds or ETF’s for intermediate goals. A portion of this money moves into bucket 1 in 5 years.

Bucket 3:

25% invested in stocks, commodities and real estate for long term growth. A portion of this money will move into bucket 2 every 5 years.

By rebalancing every 5 years, this method ensures that you are shielded from crashes like the one we just experienced, because you still have that 25% to live on for the next 5 years that is unharmed. By the time you need that money in buckets 2 and 3, the market will have rebounded at least somewhat.

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Looking for an easy, diversified portfolio of stock funds that will grow your money over time, but won’t take over your life with demands on your time? ladies, gentlemen and undeclared’s, I present the simple 7 portfolio..

Each recommendation is either an ETF, or a no-load mutual fund. Some people prefer mutual funds, and others ETFs, but there is little difference here. Most are also index tracking funds, so they are relatively low maintenance – for the set it and forget it, long term buy and hold investor. Most expense ratios are under 1%

The Simple 7 Portfolio.

1. A blue-chip U.S.-stock fund.

• iShares S&P 500 Index (IVV )

• Selected American Shares (SLASX)

• Fidelity Spartan 500 Index (FSMKX)

2. A blue-chip foreign-stock fund.

• Vanguard Total International Stock Index (VGTSX )

• Vanguard FTSE All World Ex-U.S. ETF (VEU)

• Dodge & Cox Intl. Stock (DODFX ) .

3. A small-company fund.

• Vanguard Small-Cap ETF (VB ).

• T. Rowe Price New Horizons (PRNHX)

• Vanguard Small-Cap Index (NAESX)

4. A value fund.

• iShares S&P 500 Value Index (IVE)

• Vanguard Value Index (VIVAX)

• T. Rowe Price Equity Income (PRFDX)

5. A high-quality bond fund.

• Vanguard Total Bond Market ETF (BND)

• Vanguard Total Bond Market Index (VBMFX)

• Harbor Bond (HABDX)

6. An inflation-protected bond fund.

• Vanguard Inflation-Protected Securities Fund (VIPSX)

• T. Rowe Price Infl.-Protected Bond (PRIPX)

• iShares Lehman TIPS Bond (TIP)

7. A money-market fund.

• Fidelity Cash Reserves (FDRXX)

• Vanguard Prime Money Market (VMMXX)

• Schwab Value Advantage Money (SWVXX)

I leave the actual asset allocation to you, since that will depend on your time horizon, risk tolerance and so forth.

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