In our last post, we discussed some of the basic factors for do-it-yourself investors to consider when picking no load, no-transaction-fee mutual funds for their portfolios. Included were the Morningstar® rating, category and style classifications, fund expense ratio and category ranking. While consideration of those factors provides a good start in selecting a good fund, there are many other criteria that need to be considered.

This post will focus on some but not all of the things we consider when picking our recommended funds. Many of the fund characteristics discussed below can be found free-of–charge on Morningstar’s web site. Some however, require subscription to Morningstar’s premium online service. Below are some additional things we believe you should consider when picking a fund:

Fund Inception Date: Generally, we like funds that have been around for five or more years with a proven track record. For us, consistency in performance is very important.

Management Tenure: A fund with a new manager raises question marks. Will the new manager be able to continue the fund’s good performance? How experienced is the new manager? We prefer funds whose management has been in place for at least three or four years, preferably longer. Funds with management teams can provide a smooth transition when one manager moves on.

Portfolio Composition: It’s a good idea to look a bit deeper to see what the fund really invests in. A large allocation to a particular sector could be a red flag. The management team may be trying to time the market – a tough thing to do. Is the fund investing significantly outside of its category and style classifications? It’s not unusual to see domestic stock funds investing in international stocks in an effort to juice returns. When funds stray from their stated category and style, it can make it difficult for you to maintain your target allocation and risk tolerance.

Net Assets: We try to avoid very large funds (except in the case of index funds) since it can be more difficult for large funds to find attractive investments consistent with their style and category. On the other hand, very large funds have an opportunity to spread their fixed costs over a bigger portfolio, making it easier to lower their expense ratio.

Consistency of Performance: Look at a fund’s performance over the last five to ten years. Has it been relatively consistent, or does it swing wildly from year to year. Funds with very inconsistent performance may be trying unsuccessfully to time various market sectors. We prefer the more consistent performers. Nevertheless, don’t let one bad year necessarily scare you away. Most funds tend to have a bad year in their lifetime.

Stewardship Grade: Unfortunately, only a limited number of funds have been assigned a Morningstar stewardship grade (from A-best to F-worst). The grade is based on five components including the Corporate Culture, Board Quality and Management Incentives. A good stewardship grade helps you pick funds that, on the surface at least, seem to focus on investors’ best interests.

Analyst Reports: Not all funds have a Morningstar Analyst assigned to them. For those that do, you can get a better insight into how a fund is doing and how well it is being managed.

Picking a good mutual fund that will perform consistently during good and bad markets is difficult to do. There are many other factors we haven’t discussed. In many ways, picking a solid mutual fund is more art than science. Hopefully, we’ve provided a few guidelines to help the do-it-yourself investor pick funds that will serve them well through good times and bad.

For the do-it–yourself investor, it’s important to understand how to effectively choose investments for your portfolio. Some people like to invest in individual stocks but a great many choose to utilize mutual funds and exchange traded funds (ETFs), which provide broader diversification and professional management. In this, the first of two posts, we will discuss some of the key things to look for when picking a mutual fund. Part II will focus on other more specific things to consider when picking equity and fixed-income funds.

As fee-for-service-based advisors, we help clients develop investment strategies tailored to their individual risk tolerance, utilizing no load mutual funds (including index funds) and ETFs. Periodically, we do extensive research to identify no-transaction-fee funds that we can recommend to our clients. Although we consider a large number of criteria to select our recommended funds, over the years we have come to find some aspects more important than others.

The Morningstar® rating is a good place to start. Generally, we recommend funds with a minimum of a three-star rating. It’s tempting to always focus on 5-star rated funds but all too often this year’s five star fund becomes next year’s three-star fund and vice versa. You can utilize Morningstar®’s online tools to select fund candidates that fit specific fund category (e.g. large stock, world stock, short-term bonds, etc.) and style criteria (e.g. value, growth, and blend).

Next, we focus on fees. For our clients, we ensure there are no front loads or deferred loads and look for no transaction fee funds (these vary with each brokerage company). Once you have eliminated funds with loads, focus on fund net expense ratio. Generally speaking, the higher a fund’s expense ratio, the worse it performs over the long term compared to it’s lower cost peers. Strive for an expense ratio near or below 1%. Expense ratios tend to vary across different fund categories, with international and small-cap funds usually with higher expenses.

The next factor we focus on is the five to ten-year category rank which measures how the fund has performed relative to other funds in the same category. We have found that long-term performance is generally more indicative of future performance than recent performance. Short-term poor performance coupled with a change in a fund’s managers could indicate a red flag.

A third factor we review is the Morningstar®’s evaluation of a fund’s risk. We tend to be fairly conservative and therefore prefer lower-risk funds for our clients. Investment risk is often measured by standard deviation, a statistical concept that measures the variability of a fund’s returns over time. The higher the variability or volatility of a fund, the riskier it tends to be. We prefer lower-risk funds in order to help provide clients with some downside protection. We believe it is important to focus not just on providing returns but also to avoid losses to the extent possible. We often like to quote Warren Buffett who said:

“Rule number one is: Never lose money.
Rule number two is: Don’t forget rule number one!”

Picking funds that Morningstar rates as “low risk” or “below average risk”, we believe, will serve you well over the long run.

The four criteria above will do well to get you started in your quest to identify good funds in which to invest your hard-earned money. Our next post will discuss some other factors you also need consider.

We all know that it’s a sure thing that ultimately our lives will someday come to an end. And just in case we should die unexpectedly, most people take out a life insurance policy. What many people don’t know, however, is that on any given day they have a far greater chance of becoming disabled than they do of dying. Yet, all too often clients come to us with no disability insurance.

Many employers offer disability insurance as a benefit, but that number is decreasing. In some cases, employers still provide benefits but have reduced the benefit to just basic coverage. Some only provide short-term disability coverage which covers disabilities for up to just a few months. Long-term coverage often kicks in after a period of 90 to 180 days. So even if your employer provides coverage, you may want to purchase a supplemental policy.

Social Security provides coverage for disabilities but only for conditions that will leave you disabled for at least a year or are expected to be terminal. Payouts average around 40% of pay, less for high income employees. The government safety net, therefore, while helpful, will be inadequate to meet your needs.

So what should you look for in a long-term disability policy? Most important is whether the policy covers your particular occupation or any occupation. If the policy requires that you must be unable to perform any occupation, it will be very tough to collect any benefits. You need to have “own occupation” coverage. Let’s say you are a surgeon and you lose a finger in a freak accident. If you don’t have “own occupation” coverage, it is not likely that you will get any coverage. That’s because there a many jobs that you could do without your finger.

In a recent article in the Wall Street Journal titled: “Just in Case: The Skinny on Buying Disability Insurance” by Anna Wilde Mathews, Ms. Mathews suggested that you also check the following when purchasing a disability policy:

(1) What exactly does it pay? Does it cover just your base salary or bonuses and commissions?
(2) Can you continue the policy if you change employers?
(3) Are there exclusions such as mental illness?

Be aware that you can typically only purchase coverage up to about 60% of your income. This is due to the fact that few people would ever be motivated to make an effort to return to work if their disability benefit was 100% of their previous income. Therefore you need to be sure you have a sound emergency fund and avoid over-extending yourself with fixed, non-discretionary expenses that you would be unable to cover during a potential disability.

Many people think disabilities only happen to others. Don’t get caught without this important coverage. It could be a lifesaver for your financial future.

In recent weeks we’ve been hearing much about the “recovery” of the economy. Just this last week we heard a prognosticator predict a strong “V” shaped recovery. However, last Thursday’s market plunge and other factors make us doubt the likelihood of a rapid recovery anytime soon.

Fears of continued problems in the U.S. economy and concerns about a spread of Greece’s debt problems throughout Europe resulted in a 2.6% drop in the Dow Jones Industrial Average to 10,002.18, just above the psychological 10,000 level. This was the biggest drop in the Dow, since last April.

Concerns about Europe had a strong negative impact on commodities, with crude oil down nearly 5% and gold down 4.4% as a result of a stronger dollar. Usually, economic global concerns would push gold higher. Gold’s unexpected drop is a good example of how tough it is to predict what a given market might do next.

How our economy will fare in 2010, we believe, is anybody’s guess. We’re not economists, but we expect a continued slow recovery. After all, unemployment is still pushing 10% and initial claims for unemployment for the week ending January 30th were reported to be 480,000, which was 8000 more than expected. Commercial real estate is now experiencing problems similar to the residential real estate market and foreclosures in 2010 are expected by many to be as high or higher than they were in 2009.

So what does this mean for the average investor? Don’t expect great returns for 2010 and don’t try to time the markets. Maintain broad diversification, focus on lowering investment fees and taxes and cut discretionary spending. Increased savings can help counter low or negative returns. The bottom line? Plan for the worst and hope for the best!

Many investors make a big mistake by not paying attention to investment expenses and taxes. These two costs can have a major impact on your net investment return. Commissions and advisor fees can exceed more than one percent of your portfolio, annually. Tack on fund fees that often exceed one percent, taxes and inflation and your net return may be only a paltry two or three percent on a gross return of eight or ten percent (if you are lucky enough to achieve that high of a return).

So it certainly appears that Fidelity’s recent announcement that it has reduced trading fees to $ 7.95 on all stock trades, eliminating its previous tiered plan that cost from $8 to $19.95 is good news. At the same time, Fidelity totally eliminated fees for online trades of 25 iShares ETFs (Exchange Traded Funds). This followed Schwab’s recent reduction of its online-trading commission by 31% to $8.95. Schwab also announced that it was introducing eight new ETFs that could be traded online without paying any commission.

Clearly these fee reductions were good news for investors who would like to add some core ETFs to their portfolio or who include individual stocks in their portfolio. We do see a potential downside to these lower fees, however.

If you view these lower fees as a big deal, it may be that you are trading too much. With such low fees, the total annual savings for most investors would likely not be all that significant unless they were very active traders. And some who have not been active traders in the past may now be motivated to trade more as they chase the latest hot asset class.

More frequent trading may negate the benefits of the lower fees and could very likely increase your tax liabilities. If done in conjunction with an effort to time the market, it will likely result in buying high and selling low. Market timing is extremely difficult to do. You need to be right twice. You need to buy at the right time and then sell at the right time. Doing either one of these at the right time is very difficult.

If you have a target portfolio and rebalance at regular intervals, we recommend you stick to your strategy. Rebalancing forces you to buy those asset classes that are under-allocated and sell those that are over-allocated. Be thankful that fees are coming down but don’t let lower fees tempt you to stray from your strategy and make the mistake of trying to time the market or chase that new hot investment being promoted every night on TV by some out-of-work TV celebrity.

In Charles Dickens’ famous book Great Expectations, the leading character Pip’s “great expectations” of being a wealthy gentleman were quickly extinguished when his benefactor Magwitch died. Under English law, Magwitch’s wealth was forfeited to the crown instead of to the hopeful Pip.

Like Pip, investors may find that their great expectations may end up in great disappointment. In a recent article in the Wall Street Journal by Jason Zweig titled: “Why Many Investors Keep Fooling Themselves”, January, 16, 2010, Mr. Zweig
wrote that “a nationwide survey last year found that investors expect the U.S. stock market to return an average of 13.7% over the next 10 years”.

According to Mr. Zweig, investors are not considering the impact of inflation, investment expenses and taxes on investment returns. He states that those costs will typically reduce investment returns by as much as five to seven percent (three percent for inflation and one to two percentage points each for expenses and taxes). As a result, a 13.7% gross return would net out at around 6% to 8%. And that assumes a 13.7% return for stocks is realistic. The long-term return for stocks has been around 10%. Reducing that by 5% to 7% would leave one with a net return of 3% to 5%.

Going forward, we question whether we can expect the 10% stock returns that have historically occurred. We still have a rough road ahead to recover from the current economic crisis. We can still expect a large number of residential foreclosures during 2010 as well as many commercial real estate defaults. Many are concerned that increased government spending will lead to higher taxes, higher interest rates and high inflation. If so, it’s not difficult to imagine another recession not too far down the road.

In the research for his article, Mr. Zweig asked four investment experts what “guaranteed net-net-net return they would accept to swap out their own assets”. The experts, including Vanguard Group founder John Bogle, quoted returns ranging from as low as 0.5% to 4%.

To make matters worse, if you maintain a diversified portfolio (which we strongly suggest), you can expect your non-stock asset classes to return less than stocks. This will reduce your portfolio risk but will also lower your overall net return even more.

Excessively high expectations for returns can lead one to chase the latest hot asset classes or the false promises of the next Ponzi scheme. So what can you do? Make sure your portfolio is broadly diversified and rebalanced regularly. Focus on minimizing investment expenses and taxes and pay close attention to the other areas of your finances that you can impact. Your overall wealth is a function of many factors, some of which you can control, such as credit card debt, savings and spending. Be realistic about your stock returns, focus on those things you can control and you will lessen the chance of being disappointed down the road.