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Max's Investment World Stock Market Challenge

How to Pick a Mutual Fund

Every other month, it seems, personal finance magazines holds their mutual fund beauty pageant. Each magazine has its own favorites, which often differ markedly with their competitors.

Virtually all of the magazines rate their funds on the basis of past performance. Unfortunately, as the tiny type at the bottom of all mutual fund prospectuses states, past returns aren't necessarily an indicator of future returns. Indeed study after study shows that stock mutual funds, just like stock prices, are mean reverting, meaning that the underperforming funds of today become the overperforming funds of tomorrow.

Still, it probably makes sense to eliminate funds that have done poorly over the last three-, five- and 10-year periods. After five years, mean reversion should start to work, evening out the funds with bad records. Funds that don't bounce back after that time should be overlooked.

Here's another rule: be cheap like us at Max's Investment World Stock Market Challenge.

We believe that you should only pay higher prices for higher performance. So far, studies have shown that funds with loads, or sales commissions, don't perform any better than no-load funds. And funds with high annual expenses aren't, in general, better performers than funds with low expenses. High expenses can reduce the performance of a fund's annual return by a half of a percentage point or more.

There are 700 no-load funds with low expenses to choose from, cutting the field of choices considerably.

You can also safely ignore funds and fund managers with less than a three-year track record. Why? How do you know how they perform in up and down markets? You don't, so be safe rather than sorry.

Pick a couple of funds with different objectives, such as funds that invest in blue chips, small stocks and international stocks. That way, you further diversify risk and most likely will increase returns.

Bottom line: You can be just as good if not better a judge of mutual funds than the personal finance magazines. Any decent library will have the Morningstar and Lipper ratings of mutual funds, which should help you come up with at least a couple of winners.

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