Mutual Funds Pitfalls

Picking a mutual fund from among the thousands offered is not easy. Following are some common pitfalls.

Prior to investing in a tax-exempt or tax-managed fund, it is best to determine if the tax savings will off-set the possibly lower returns. Additionally, these funds are inappropriate for IRAs and other tax-sheltered account types.

Match the term of the investment to the time you expect to keep it invested. Money you may need right away (for example, if your car breaks down) or expect to use soon should generally be in a less volitile fund, such as a money market. Money you will not need until you retire in decades (or for a new born's college education) can reasonably be invested in longer-term, higher-risk investments, such as stock or bond funds. Putting money you will need soon in volatile investments risks having to sell them when the market is low. Investing long term in very stable investments, on the other hand, significantly reduces potential returns.

Expenses matter over the long term, and, all other things being equal, cheaper is better. You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio.

Several sector funds often make the "best fund" lists each year. However, which sector varies from year to year. Most sectors are vulnerable to industry-wide events that can have a significant impact on your holdings. It is generally best to avoid making these a large part of your portfolio.

Closed-end funds often sell at a discount to the value of their holdings. You can sometimes get extra return by buying these, if you are willing to hold the fund until the discount rebounds. Some hedge fund managers use this gambit. This also implies that buying them at the original issue may be a bad idea, since the price will often drop immediately, due to liquidity concerns.

Mutual funds often make taxable distributions near the end of the year (semi-annual and quarterly distributions are also fairly common). If you plan to invest money in the fund in a taxable account, check the fund company's website to see when they plan to distribute dividends and capital gains. Investing just before the distribution results in part of your investment being returned to you as taxable without increasing the value of your account.

Read the prospectus, even though it may seem boring. It should tell you what risks will be taken with your money, among other vital topics. Check the return and risk of a fund against its peers with similar investment objectives, and against the index most closely associated with it. Be sure to pay attention to performance over both the long-term and the short-term. A fund that gained 50% for a 1-yr. period (which is impressive), but only 10% for the 5-yr. period should raise some suspicion, as that would imply that the returns on four out of those five years were actually very low (if not straight losses) as 10% compounded over 5 years is only 61%.

Diversification can reduce risk. Depending on your risk tollerance and how long you will be investing it may be advisable to own some stocks, some bonds, and some cash. For longer-term investments, there may be added reason for some of the stocks to be foreign. You might not get as much diversification as you think if all your funds are with the same management company, since may share research and recommendations. The same is true if you have multiple funds with the same profile or investing strategy; their returns will likely be similar. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher. Buying individual stocks exposes you to company-specific and industry-specific risks, and if you buy a large number of stocks the commissions may cost more than a fund will.

The compounding effect is your best friend. A modest return over a long period of time equals a large return overall.