Most fund buyer look at past performance first, then at the manager's reputation, then at the riskness of the fund, and finally (if ever) at the fund's expenses.
The intelligent investor looks at those same things-but in the opposite order.
Since a fund's expenses are far more predictable than its future risk or return, you should make them your first filter. There's no good reason over to pay more than these levels of annual operating expenses, by fund category:
- Taxable and municipal bonds: 0.75%
- U.S equities (large and mid-sized stocks): 1.0%
- High-yield (junk) bonds: 1.0%
- U.S equities (small stocks): 1.25%
- Foreign stocks: 1.50%
Next, evaluate risk. In its prospectus (or buyer's guide), every fund must show a bar graph displaying its worst loss over a calendar quarter. If you can't stand losing at least that much money in three months, go elsewhere.
It's also worth checking a fund's Morningstar rating. A leading investment research firm, Morningstar awards "star ratings" to funds, based on how much risk they took to earn their returns (one star is the worst, five is the best). But, just like past performance itself, these ratings look back in time; they tell you which funds were the best, not which are going to be.
Five-star funds, in fact, have a disconcerting habit of going on to underperform one-star funds. So first find a low-cost fund whose managers are major shareholders, dare to be different, don't hype their returns, and have shown a willingness to shut down before they get too big for their britches. Then, and only then, consult their Morningstar rating.
Finally, look at past performance, remembering that it is only a pale predictor of future returns. As we've already seen, yesterday's winners often become tomorrow's losers.
But researchers have shown that one thing is almost certain: Yesterday's losers almost never become tomorrow's winners. So avoid funds with consistently poor past returns-especially if they have above-average annual expenses.
- The Intelligent Investor, Benjamin Graham
