Learn the Basics of Picking Funds for Your Portfolio

You probably would agree that investing is a smart move for your future, right?

Alright, now it gets trickier.

"What should I be investing in?"

That's a more difficult question to answer.

While this post is 100% NOT personalized investment advice, I do want to show you a few ways to evaluate selecting investment funds.

Why Funds?

Notice in the previous sentence where I said "investment funds." That was intentional.

That means not handpicking individual stocks and bonds.

If you're having to ask about the most appropriate investment, then selecting an investment manager is probably the right fit.

Think mutual funds, ETFs, target date funds, index funds, REITs, etc.

(And if that just overwhelmed you, I'm about to explain.)

Most funds are a basket of stocks and/or bonds.

So think of it this way.

You could go out and buy a bag of Doritos, or you could buy the variety pack that has Cheetos, Cool Ranch Doritos, Nacho Cheese Doritos, Funyuns, etc.

Now imagine that your entire financial future depended on what bag of chips is most desired buy Chip Enthusiasts.

Would you rather go all in on that bag of Doritos, or would you rather buy the variety pack with multiple different options, so that you had a better chance of owning the most coveted chips?

That decision is called "diversification."

So now let's move on from Chip-onomics.

Costs of Funds

Now because you've decided to let an investment company pick your stocks and bonds, they want to get paid for their effort.

The percentage the investment company gets paid is known as an expense ratio.

The amount the investment company gets paid is its operating expenses.

And the expense ratio is simply the operating expenses divided by net assets (think total amount of money in the fund).

Why is expense ratio important?

Well, because the more you pay the investment company, the less that goes toward your returns.

You want to make sure you're getting the most bang for your buck.

Here's a general rule of thumb: the more work the investment company has to do, the more you pay.

Example 1: XYZ Index Fund is largely algorithm-based. The fund company has computers that tell them exactly what trades to make based on whatever the stock market does.

This fund would probably have a low expense ratio because there's not a lot of activity by the investment company.

Example 2: ABC Active Fund owns about 30 stocks, all which are evaluated by a team of finance nerds. They thoroughly research the industry, demographics, and geography of each stock before eventually making a strategic decision to buy or sell.

Because this funds has a lot of legwork from the investment team, this fund would likely have a higher expense ratio.

Remember this: active funds are designed to try to beat the market. If you want to beat the market, you typically have to pay for it.

Passive funds, like index funds, are designed to match the market. Since you are going to simply tie--not win, not lose--the mechanics of the fund cost less.

Your Investment Pie Chart

I'm about to use an investment word: asset allocation.

It's a fancy word for the pie chart that your investment statements may have.

Essentially, when you invest, you'll own a certain amount of:

• Large US growing stocks
• Large US established stocks
• Medium US growing stocks
• Medium US established stocks
• Small US growing stocks
• Small US established stocks
• International stocks in developed economies
• International stocks in emerging economies
• Short duration bonds
• Intermediate duration bonds
• Long duration bonds
• Money market funds
• Foreign bonds
• Real estate
• Commodities

And to make this even more confusing and daunting of a task, how much you own of each category matters more than which fund you pick to own.

In other words, however big the slice of pie of Large US Growth companies (for example) you choose to own will affect your returns infinitely more than picking the best Large US Growth fund.

Vanguard determined that about 88% of an investor's returns can be explained by asset allocation (Vanguard Asset Allocation Study).

The best performing asset class is fluid, meaning that the categories above may have a top performer one year and an entirely different one the next.

The US may have been the best performer in recent history, but from 2000-2010, US stocks underperformed international stocks.

Healthcare companies were exploding during COVID-19 times, but now they're less exciting.

Uncertainty about the future is why it's typically a good idea to have an assortment of funds in different categories.

Long story short, investing is way more than just picking a good fund.

Selecting Funds

Considering that we now know that funds have certain costs and that we should own funds in different parts of the market, let's try to evaluate how to pick certain funds.

Remember our active vs. passive fund comparison?

Let's go a step further.

Active funds are best owned in a couple situations:

1. Inside a tax-deferred account (like a 401(k) or IRA)
2. When the markets are inefficient

Active funds, since there's lot's of trading and activity going on inside the fund, have capital gains and income that is passed to the investor in the form of a capital gain distribution.

If you owned active funds in a taxable brokerage account, you'd be responsible for the taxable gains every year. That's why I suggest using active funds more in retirement accounts, since the gains are deferred.

Now what does "inefficient" mean?

Inefficient markets mean that the prices of certain stocks are not reflected in the companies true value.

For example, if a stock was priced lower than its true expected value, the active investor would probably buy the stock.

Passive funds use the opposite approach. Passive funds expect the market to be efficient, meaning that there's no information available about a company that isn't already reflected in the stock's price.

Passive funds don't have as much trading happening as active funds, usually leading to less capital gain distributions and possibly a reason to use them for your taxable brokerage accounts.

Since passive funds cost less, you would probably select them for market sectors where information is readily available.

Think about Large US Growth companies, like Apple, Nvidia, Amazon, etc. There is already a wealth of information about these companies, so it would be hard for an investment manager to find something that everyone else doesn't already know.

However, a biotech fund that selects small, off-the-radar companies who are innovating in healthcare--that might be a better opportunity for an active fund, since there's less research on all those companies.

"What If I'd Rather Someone Manage My Investments for Me?"

If everything up to this point still has you thinking:

• "Ugh, sounds great, but I don't have the time to research any of that stuff."
• "I'm still confused. I don't understand money stuff, but I know I need to do something."
• "I'd rather spend time doing what I love than becoming an investing expert."

Then good news, you have options.

For some people, their situation isn't all that complicated, and they're comfortable managing their own investments. Kudos to them. That's not why I'm here.

I'm here for those that want a solid investment strategy.

I'm also here for those who have said "I want to not be worried about money as soon as heavenly possible," which comes with a laundry list of questions outside of investments.

If that sounds like you, try starting with one of these baby steps:

• Send me a DM with your questions
• Visit my firm's website
• Download your free copy of 9 Common Mistakes When Retiring Early