5 Mistakes Investors Make in Picking Mutual Funds

I'm a short term mutual fund trader. I've been trading my retirement account since 1996 and averaging 20% plus returns in a way that allows me to sleep soundly at night. Now, I won't get into my mutual fund strategy because most investors prefer to be long term holders and many just get too confused when they are explained the benefits of short term trading. What I have come across in my discussions with investors is the mistakes they make when it comes to understanding or picking mutual funds. It is said in the industry that 80% of mutual funds underperform the stock market; however the pundits out there will tell you to be long term investors. So I leave with the top 5 mistakes, in case you prefer to listen to the pundits. And afterwards, please read the article attached by the Oracle of Omaha, Warren Buffet's excerpts from his annual letter to his investors on the visions of what to expect for the stock market and investments going forward.

Mistake 1

Not understanding the objective of the fund. This means knowing what their benchmark is. Each mutual fund has an index benchmark they try to beat. For instance, a mutual fund manager might be using the S& P 500 which is the index that tracks 500 large cap corporations. So your mutual fund name might say something like Fidelity Large Cap Funds or Fidelity Large Cap Growth Funds. Large cap funds means stocks that strive for growth and income through dividends. Know your funds objective and see if the mutual fund you have selected is outperforming its benchmark, in this case it would be the S&P 500. If it is not, then you might want to look for a new fund.

Mistake 2

Not understanding your own risk tolerance. Can you sleep at night while your money is in the market? If not, then you might want to look at the Beta of the stock or fund which is the volatility indicator. A high beta number has a higher volatility and risk and a low beta fund is lower volatility and less risk. Click "here" for more explanation of Beta. Another way to offset that feeling is diversification. See Mistake 3.

Mistake 3

Not being diversified in your funds. You've heard of the old saying, "don't put all your eggs in one basket"? That's what being diversifed means. However, you also need to consider your age. When you are young like the 20s to 30s range, you can and should take more risk because you have "time" on your hand. Mutual funds that are geared towards technology, international, or emerging funds would be more for a younger investor's weighted risk.

And on the other hand, as you age, and get closer to 5 years before retirement you should reduce that risk and add more fixed income or low beta mutual funds that deal more with income rather than growth. These fund names would include "income" in the mutual fund title; i.e. Fidelity Income Fund. They invest mainly in stocks that produce dividends which produce the income for the fund. However, in this day and age, with inflation on the rise, you can lose money if you are overly cautious. The reason is because inflation could creep up higher than what your fixed account yield might pay out.

Mistake 4

Cost averaging in a losing fund. You've heard that you should cost average your deposits on a consistent basis to average down the cost basis of the investment. Well, what if you are picking the wrong fund? An example, if you picked a mutual fund that has been either meeting or underperforming their benchmark then you are giving good money to a poor performing mutual fund manager. You may need a lot of time on your hands to make this up even if it comes back to a break even.

Here is an example. Let's use the S&P 500 as the benchmark and assume your fund manager has met the same performance for the S&P 500 for the year. Are you aware that for the past 8 years since the year 2000, the S&P 500 has been down about 10% to where it is today. Not only did you not receive a return on investment but you lost your principle. Click "here" to see the decade chart for the S&P500.

However, if you were invested in the S&P 500 for the past 10 years, you would be up only 2 ½% per year annual average. If you put your money in a fixed account over that same 10 year period, you would have done better plus you would have slept worry free at night. This is why it is important to not cost average. What you can do is put your deposits in the money market and when we have big drops, drop those deposits in at once or gradually. However, make sure the fund manager is outperforming compared to his/her benchmark. This way you can take control of when the deposits go in. You don't want to set it and forget it!

Mistake 5

Not knowing when to rotate your mutual fund selection. If you are reading about a trend and seeing the hot industry sectors moving and you are in a sector that is not performing well; you should rotate out of your fund to the industry that is in favor or at least move a portion of your money based on your risk tolerance. It's important to rotate your mutual funds now and then because the market is always changing.

In all my 35 years of investing and 12 years of trading, I have never seen a market like this. Long term investing is not my choice because I prefer to take my profits and sleep better at night. However, I do understand the average person is a long term investor. We are in different times now and going forward it is not going to be easier. This is truly a global market and it pays to know what is going on outside of the US. You also need to take time out and do your own due diligence because it's YOUR money! In order to beat inflation you have to invest your money. However, do not become complacent. I leave you all long term investors with the Oracle of Omaha's message, click "here".