By Allen Giese, ChFC®, CLU®
Imagine you are sitting there looking at the list of mutual funds in your 401(k) or retirement plan, and you’re trying to decide “Which are the better funds? Which funds should I pick?” Or maybe you are just shopping for funds to invest in. The point of this video is, where do you start in the process to determine, out of all the fund choices you have, which funds you should focus on? Because there is one metric—and it’s not performance—that will start you down the right path to telling you what you really need to know when deciding if one fund has a leg up over another.
Hi, I’m Allen Giese, founder and president of Northstar Financial Planners in Plantation, Florida. Now, when most people are trying to decide which funds they should invest in, the first impulse they have is to look at the past performance. “Who had the best performance and let’s go with that one” is basically how it goes. Well, that couldn’t be more wrong. There’s more than enough solid evidence out there to conclude that chasing top-performing mutual funds leads one well down the path to mediocrity.
Seriously, you know that little disclaimer you see on basically all the fund literature that says something to the tune of “Past performance is not an indicator of future performance”? That’s actually true! They are telling you, right up front, that picking a fund based on its past performance is really not a good idea. So why do people do it anyway? Well, it’s the way we are wired, and it’s a behavioral bias. We see the success and assume it will continue when, in actuality, we find the persistence to be no different than we’d expect by chance.
So where does that leave you? What other metric could you start with that is, perhaps, more meaningful?
In my opinion and experience, the most meaningful metric is the mutual fund’s costs and expenses relative to its peers. That’s kind of the key—you have to make sure you are comparing apples to apples. In other words, it’s probably not fair to compare a U.S. stock fund to a bond fund, for example.
Let’s assume you have four U.S. large company stock funds in your 401(k) to pick from, and you’ve decided you want to have U.S. large companies represented in your account. The first best step you can take is compare the costs or expenses of each of the four funds. But where do you even find the cost of a fund? Sure, it’s in the prospectus, but seriously, do you have the prospectus? And does the thought of paging through a 100-page document looking for an expense figure just not excite you? Yeah, me neither.
A quick internet search is probably your best answer. Two sites that carry this information that are big and well known are Yahoo Finance and Morningstar.com. All you need to do is type in the symbol or the name of the fund, and up comes the information you need. For example, on this screenshot from Morningstar’s site, I’ve circled the fund’s administrative expense so you can see where it’s displayed. I’ve purposely blurred out the name of the fund because I don’t want to appear that I am endorsing this particular fund in any way. And I’m not. This is just an example of where to find the information.
So here’s how to use this information. Let’s go back to our example where you decided to include U.S. large company stocks in your account and you have four funds offered that all invest in U.S. large companies. Now, if one mutual fund is investing in these companies for, say, a cost of 0.10%, or one-tenth of 1%, and the other three are in that same market space for 1.0% or more, then I have to ask myself, “Are those mutual funds that are charging me 10 times the amount of the first fund really going to provide me a return that makes up that kind of difference?”
Now, there is a whole bunch of reasons why one fund costs more than another. But if we’re really comparing apples to apples and one fund is costing more than another fund and they are both more or less holding stocks from the same asset class, then it just makes sense that the lower-cost fund is probably going to net you a better return. Not only do those other three have to outperform the first one, but they have to outperform by nearly 1% just to be even!
So costs matter, and they matter in a big way. And it’s a great place to start, and maybe even in some cases finish, your analysis and help you make a decision on which funds to choose and which to avoid. Compare the costs.
Thanks for watching, and if you want to talk more about this, I’d love to hear from you. Or if you’d like to have a second opinion on your own finances, we can do that too. In any case, thanks for watching and have a wonderful day!