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Investing and selecting mutual funds

By David Luhman on Sun, 06/28/2009 - 17:52

Investing and selecting mutual funds

Dollar cost averaging

In addition to diversifying into different assets, you also should diversify your investments over time using dollar cost averaging.

Dollar cost averaging is a simple technique, and if you're investing on a monthly basis, you're already taking advantage of it.

Suppose over the course of a year you want to invest $3,600 into a stock fund in your 401(k) account. To make saving easy and regular, you have your company withhold $300 from your paycheck each month.

Under your plan you'd invest $300 in January. Let's also assume that the market hit an all-time high in January. The next month the market goes down by 10 percent.

So you've lost 10 percent on the money you invested in January, but if you continue with your regular investments, your $300 will buy more shares in February than it did in January because of the drop.

By investing regularly, I hope you see that dollar cost averaging forces you to buy fewer shares when securities are expensive, and lets you buy more shares when they're cheaper. It's not exactly market timing, but it has a similar effect.

Dollar-cost averaging can't guarantee you'll make a profit, but it can reduce your risk significantly. To see the power of dollar cost averaging, consider investing in stocks during the Great Depression.

From 1929 to 1932 stock prices fell 90 percent. However, if you had used dollar cost averaging from 1928 to 1938 you would have shown a profit of about 7 percent per year.

Bad way to select mutual funds

Before we get into the topic of selecting specific mutual funds, I'd like to say a few words about using funds to beat the market.

Unfortunately, many people don't pick funds very well. They just grab the most recent copy of Money magazine and open to the page titled "Best Performing Mutual Funds". They look to the top of the list, and send their money to the number one fund because, after all, everyone wants to invest with a winner.

Although there are worse ways to select a mutual fund, this is not the best method. The problem with this method is that you're investing based on past performance. If you send in money to the fund today, you don't care what the fund did yesterday, you care about what it will do for you tomorrow.

Investing in yesterday's winners

Often, when you follow the "invest in yesterday's winners" strategy, yesterday's winner's become tomorrow's losers. With over 6,000 mutual funds available, to get to the top of the list the number one fund may have had to invest in risky securities.

When these risky securities came into fashion, the fund did well. The fund rose to the top of the fund rankings and money is now pouring into the fund.

But the fund managers don't know what do with all this new money, so they invest in securities that they don't understand. Soon, the market will switch away from the securities that made the fund a hit in the first place, and the new investors will wind up taking losses.

Another problem with the "invest in yesterday's winners" strategy is that you'll probably pay more in expenses than necessary. When a fund has done well, fund managers know that many people will pay for yesterday's performance, so they place heavy sales commissions on the fund or raise the fund's management fees. After paying all these extra expenses, it'll be even tougher for you to beat the market.

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