BOSTON – Long-term happiness with a mutual fund is often traced to what investors were thinking when they made their first purchase.
But if the bull-to-bear-to-bull swing of the last decade, the fund scandals, huge interest-rate shifts and more have taught us anything, it's that keeping your selection process static and rooted in the past is folly.
Developing a system based on your personal beliefs is crucial. That said, here is my six-step program -- which started many years ago with nine points -- to use as a guide. Come up with your own plan of attack, writing down your criteria in order of importance, before buying your next fund.
Step 1: Determine why I want or need a new fund
Hobbyists make impulse buys, select the flavor du jour or add to a collection rather than building on a strategy. Deciding first what the money must accomplish -- whether it's diversification, growth, stability, income or something else -- allows me to properly set my expectations.
Step 2: Cut to the asset class first then apply the selection criteria
Generally speaking, I dislike funds with above-average costs and managers with a tenure of less than 10 years. I avoid funds with sales charges, not because load funds are bad but because they're inappropriate for someone who doesn't rely on an adviser for guidance.
I also make sure the minimum initial investment -- or regular deposits to avoid the required deposit -- are within my budget; there's no sense fixating on a fund you can't afford.
Step 3: Learn the story of the fund and its manager
Success depends on having trust and confidence in the fund, whether it is the manager's expertise or the common-sense simplicity of indexing.
To find a compelling reason to buy, delve into a fund's newsletters and reports, which may offer insight into the manager's style and discipline. If a fund's own paperwork doesn't help convince you to take a leap of faith, keep looking.
This is also the time to factor the fund firm's past behavior into play. If there are scandals or troubles in management's past, you must be convinced the worst is over or you should move on.
I want to finish this step able to articulate my knowledge of a fund well enough to justify its place in my portfolio to, say, my wife; if I can't explain my interest now, I won't be able to stick with the fund when the market gets hairy.
Step 4: Examine peers and check returns
When performance is the first selection criteria, investors tend to chase hot numbers. While I want the fund's asset class to drive the decision more than raw results, you ignore the past at your own peril.
My initial cut is for funds in the top 25% of their peer group over the last five years. Consistency is key too; I'll sacrifice some upside potential for a smooth ride.
Step 5: Choose the finalists, get independent research and read the prospectuses
I look for holdings that are consistent with a manager's discipline and examine what a fund is allowed to invest in, which shows how the portfolio might change over time. If a fund's holdings -- or a Morningstar, Value Line or Lipper Leaders report -- don't sit right with me, I move on.
For tie-breakers, I compare expense ratios and turnover (the lower the better on both fronts), tax-efficiency (unless the fund is in an IRA), and overlap with my current holdings.
Step 6: Jot down my thinking and write the check
I start my file on any new fund with a detailed list of the factors that convinced me to buy, which makes it easier years later to answer the question "Would I buy it again today?" Then I fill out the account application.
If I'm not nervously excited by the potential of my pick, something is wrong. If that rush is missing, I hold off, refine the search and start over.
Copyright (c) 2007 MarketWatch, Inc.