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Stocks are fun to banter about in the locker room, but beginning investors should take a hard look at mutual funds. Here's why.
First, you get the advantages of professional management, so you've got an expert on your side while you're learning the ropes. Second, because most funds own dozens of stocks, you automatically reduce your risk because one stinker won't kill your returns. Finally, you can have a life because you won't have to watch your stocks every day.
But picking the right funds takes some real care.
Here are seven ground rules for pinpointing low-risk funds. Even better, you don't have to do the legwork. You can use MSN Money's Fund Screener to find funds meeting all of these requirements in a snap. You can get to the screen by going to the Investing home page and clicking on "Fund Screener" under "Funds" on the left side of the page. The screening parameters below will tell you how to set the criteria on the Fund Screener.
Don't waste time on funds you can't buy
Don't take it personally, but some funds just don't want your money:Closed to new investors. Some managers, especially those running small-cap funds, feel that there's a limit to how much they can invest before they run out of good candidates. So they stop opening new accounts, rather than channeling shareholders' money into second-rate stocks.
- Screening Parameter: Closed to New Investors = false
Big spenders only. Some funds establish high minimum investments to open an account. Ongoing expenses such as preparing and mailing statements, as well as handling investor questions, cost just as much for small accounts as for larger ones. For them, very small accounts are not worth the trouble.
- Screening Parameter: Minimum Initial Purchase <= $2,500 (adjust this value to suit your needs)
Institutions only, please. Some funds take that reasoning to the limit and cater to pension plans, trust funds and other institutional investors.
- Screening Parameter: Institutional Investors = false
Stick with the top of the class
Next, look for funds where the historical reward/risk balance tilts in favor of reward -- for you!Morningstar, an independent investment research company, rates each fund by comparing its historical returns with its historical volatility, which is a risk measure. Funds with the highest return/risk ratios get five stars from Morningstar, and those with the lowest ratios get one star.
Morningstar compares each fund with others in the same category, say, small-cap value funds or tech growth funds, etc. The funds with the best return-to-risk ratio in the category get five stars and the worst get one star, regardless of whether the category as a whole is on fire, or in the dumpster. A fund must have been operating for at least three years to be rated.
Morningstar's rating system is far from perfect, and there's no guarantee that all five-star funds will shine in the future. But it's a good place to start. I've found the best candidates within the ranks of four- and five-star rated funds.
- Screening Parameter: Morningstar Rating >= 4 stars
Say no to high risk
So far, we've focused on funds where the potential reward exceeds the risk. But some of those funds could still be high risk. We'll disqualify those next.Morningstar, along with most other fund raters, uses volatility as a stand-in for risk. Volatility measures how much the fund's returns have bounced around in the past. Volatile funds keep you up at night, while low-volatility funds let you sleep like a baby. Morningstar's risk rating compares a fund's historical volatility with all other funds in its category.
The ratings, in descending order, are: high, above average, average, below average and low. Of course, the lower the risk, the better. However, the lowest-risk funds may not have sufficient returns. So specify funds with "below average" or "low" risk ratings.
- Screening Parameter: Morningstar Risk: <= Below Average
Standard deviation, that eye-glazing statistical term, measures a fund's volatility on an absolute basis, instead of comparing it to like funds. My own research, and that of others, found that high-standard-deviation funds underperform those with low scores in that department. What's low? Standard deviations below 25 are low risk (lower is better) and those of 30 and above equate to high risk. Stick with low-risk funds.
- Screening Parameter: Standard Deviation: <= 25
Morningstar's research shows that a fund's portfolio P/E works well to predict future risk. The portfolio P/E is the (weighted) average price-to-earnings ratio of the fund's holdings. I've found that funds with P/Es above 30 seriously underperform lower P/E funds. So stick with P/Es below 30, and lower is better.
- Screening Parameter: Fund P/E <= 30
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