Mutual Fund Investing Mistakes

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Mutual fund investing is so simple that many people convince themselves they can outsmart the markets.

Bad move. The only way to build wealth with mutual funds is to avoid the urge to be recklessly aggressive or to second-guess major moves in the economy.

These are the biggest mistakes being made now by mutual fund investors:

  • Mistake #1: Avoiding stock mutual funds because you think they're too risky for you. By now, most people realize that stocks are an important part of every portfolio. The big mistake they make is not putting enough into stocks.

    Most investors in their 40s and 50s should have at least 60% of their portfolio in equities. For younger people with a longer investment horizon, the portion in equities can approach 100%.
  • Mistake #2: Avoiding the stock market when it's high. The simple fact is that the market is always too high. If you invest the same amount consistently--once a month or once a quarter--you'll do well over the long term, regardless of how the market is doing at any given time.

    The lesson: Don't base mutual fund investment on emotion or guesswork. Invest according to your schedule. If now is the time of month or the quarter when you typically buy shares, just do it, even if the market is high. In the long run, stock prices will be even higher.
  • Mistake #3: Following the leader. Financial magazines pour praise on whichever mutual funds and fund managers are hot. Lately the hot sector has been technology mutual funds. Before that it was emerging markets. Before that, gold.

    Before you buy specific mutual funds, select the types of funds you must own to achieve your long-term goals. The younger you are, the more risk you can take. Such mutual funds include those that invest internationally or in small, little-known companies. Invest in those funds regularly.
  • Mistake #4: Worrying about asset selection, rather than asset allocation. In a study of the performance of large pension funds, researchers found that decisions about how people divided their money among stock mutual funds, bond mutual funds and cash accounted for 85% of results.

    Meanwhile, asset selection--picking individual securities--only contributed to 20% of performance. This adds up to more than 100% because market timing accounted for a negative 5% of results.

    The lesson: Asset allocation--how you divide your assets among different type of mutual funds--is much more important than picking the next hot fund.
  • Mistake #5: Failing to re-balance when markets surge. Suppose the perfect portfolio mix of stocks and bonds for you is 50% stocks and 50% bonds. This means half of your portfolio should be made up of stocks, and half bonds. If the value of your bond mutual fund declines, and bonds now make up only 40% of your portfolio's worth, you must realign the assets.

    Strategy: Put your monthly or quarterly investment into bonds--and even trim profits from stocks--to bring your holdings into balance. When bonds bounce back, trim them in favor of stocks.

    This is not a guarantee that you will buy low and sell high--but its a strategy to help you sell when things go up and buy when they go down.
  • Mistake #6: Re-balancing too often. Adjust your mix no more than twice a year, as you review your overall portfolio. Don't act until one asset class is around 10% out of whack, or else the market's volatility will whipsaw you.
  • Mistake #7: Taking excessive risk. This is always tempting in a bull market. The rising tide lifts nearly all stocks, but some inevitably rise higher than others. Hold the risk of your over-all portfolio to your personal comfort level.

Excerpt from: Bottom Line Year Book 1997, based on Gerald Perritt, portfolio manager of Perritt Capital Growth Fund.

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