Most people with a 401k have a group of mutual funds and or ETFs to choose from. For your own account than you have thousands to choose from. Here are some ways to choose the best mutual funds and ETFs that are right for you.
It seems when talking to people that have a 401k plan or
something similar through their work, they have no idea what funds are in their
retirement plans. They do not want to know or learn what they own, even though
it is all about their future.
Risk Tolerance
Risk tolerance is defined as the degree of uncertainty that
an investor can handle in regard to negative changes in their portfolio.
What is your tolerance for risk, usually the younger you are
the more risk you can take. That’s because you have more years to make up for
losses. And the closer you get to retirement and the closer you get to the time
you will need your money, the more safe funds you need to have.
Diversification
Diversification is basically not putting all of your eggs in
one basket. Diversification also helps to reduce the risk of your portfolio
going down too much in a down market.
When you don’t have much money to invest in your funds, it
can be a little harder to diversify, but you still can and should.
If you have a small amount of money and don’t really have
the time to diversify yourself, you can buy what’s called an Asset
Allocation fund. These funds are already diversified.
There are also what’s called Lifestyle funds, they
will have names in them like 2010, 2020, 2030 etc. These funds are designed for
someone who will retire and need their money by the year in the funds name. If
you are going to retire in 2030, then you might consider owning a lifestyle
fund like the Fidelity 2030.
Many times when one sector or part of the stock market goes
down, another part or sector will go up, and if you own some funds in both of
those sectors, that is what diversifying will do.
Usually when stock market goes down bond funds will go up
and visa versa. So owning a bond fund along with a stock (equity) fund, you
will be diversified in that way.
Diversifying by your age, if you’re in your 20s or early
30s, you might just have all stock funds in your portfolio and no bond funds.
As you move into your 40s you start to have the more bond funds in your
portfolio. Maybe by 50 years old, you might have something like 35% bond funds
and 65% stock funds.
Finding the Best Mutual Funds
You do what’s called screening. You are screening for the
best funds that meet your criteria in a certain sector of the stock or bond
market.
I always screen for only no-load funds. Load funds
just take away a little bit more of your money and there are plenty of very
good no-load funds.
There are several good fund screeners on the internet, and
you can use all of them to get your results. I am most familiar with the one on
Morningstar.com.
Manager tenure can be very important to look at. If
the managers change all the time, then any of the past results of that fund can
never be relied on. If for example a fund has done great in the 5 year or 10
years and then that manager leave, you cannot use the historical returns as any
kind of guideline. I like a fund to have a consistent manager running the
certain fund.
Stars: I would also only look at 4 or 5 star funds of
the Morningstar rating system for both risk and return.
Risk: The higher the risk the more volatile the fund
will be, the more it could go up in an upward moving market and the further if
can go down in a down market.
Beta is a term that defines volatility, the higher
the beta the more volatile the fund is. A fund with a beta of 1 should move
with the overall stock market. A fund that is more volatile then the overall
stock market would have a Beta over 1.
Expense ratio: Every fund has this, like all fees the
lower the better. Small cap funds usually have a higher expense ratio than
large cap. Index funds have very low expense ratios and when comparing expense
ratios, compare only with funds in the same sector.
You can make most of these “category average” until you get
used to these and know exactly what you want in a fund.
Then click on Score. From there you can change how important
each of these criteria are on a scale of 1 to 10. You can also customize your
criteria.
Comparing Mutual Funds
If you are looking to choose the best funds out of a list of
funds such as in your 401k options, I like to use the compare funds tool at
Morningstar. It is free, but you will have to register to use it.
- Enter in the symbols of the funds you are choosing from in the upper box.
- When you enter in your list of funds, you are trying to find the best one out of your choices. It is important to compare apples to apples. For example, you shouldn’t compare bond funds with stock funds since they are completely different.
- You can sort this list any way you want to, for example sort by the best YTD (year-to-date) returns, or 5-year returns or lowest expense ratios etc.
- When you have the comparison results on your screen, you can look at each one of them and see all the data for them by clicking on the funds name.
Conclusion
When it comes to your own retirement plan or 401k plans, you
have to know what is going on with them. Do not let some HR person at work
decide for you, you can ask them questions, but make your own decisions. The
more you learn, the better questions you will be able to ask the financial
planner.
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