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Special Report

Golden Rules of Mutual-Fund Investing

The following is an excerpt from a recent speech Morningstar analyst Bridget Hughes delivered at the Atlanta Journal Constitution's investment conference.

If it seems like you're swimming in a big sea of meaningless numbers, I'm not surprised. If you feel bombarded by mutual-fund advertisements, you're not alone. And if you don't know who to listen to when it comes to investing, welcome to the club.

With more than 10,000 mutual funds out there, how could anyone not be overwhelmed? When you take into account the sea of information on stocks and bonds, all the change in financial markets, and your lack of time or desire to research investments, investing right seems almost impossible. Believe me, I know how some of you feel. This is my job and I love it, but I've got a five-month-old son, and often, all I want to do is play.

There's bad news and good news.

The bad news is that it is not easy to manage all that information. And it is easy to make mistakes.

The good news, though, is that practically all the information you need to make smart investment choices is out there, whether you invest on your own or you use a financial planner. And if you do a little homework, you'll find investing in funds really isn't that hard. And, it gets easier as you become more experienced.

Following are some tips, or golden rules, to help you invest better, to help you reach your goals, and to help you free up time to play.

Know Yourself
First and foremost, you must know yourself.

Try to get an idea of how much risk you're able to handle. Do a gut check. If your $10,000 investment turning into $6,000 doesn't sit well with you--even if it could subsequently bounce back--perhaps an emerging-markets fund isn't the fund for you.

You also need to do a reality check. What are your goals? If you need to turn $10,000 into $50,000 in a year and a half, an intermediate-bond fund probably isn't the answer. Work on setting realistic expectations for both your goals and your funds.

Finally, know your portfolio. Look for areas that are over-represented and for those that are lacking. For example, is your portfolio overly concentrated in the large-cap growth area? Are you missing investments in small-cap stocks? And don't forget to account for the cash that mutual funds hold.

Know What You're Buying
Once you've "found yourself," spend some time looking under the hood of funds.

Rather than depend on prospectus objectives, use Morningstar's categories and the style box, which group funds based on what they actually own, to help diversify your portfolio. You don't need to cover every square, but you probably want to be spread out a little bit. Another way to use Morningstar categories is to help assess potential risks. In general, large-cap value funds are less risky than small-cap growth funds.

Examine sector weightings to find out what will drive the portfolio's returns-both up and down. And know that funds with large stakes in just one or two sectors will likely be more volatile than those that are more evenly diversified. To gain a little more context, look at a fund's sectors historically. Does the manager move in and out of sectors frequently and dramatically? If so, the fund could get burned if the manager makes the wrong call.

Check out how concentrated your fund is. A portfolio with just 20 or 30 stocks or one that puts most of its assets in just a few stocks will likely be more volatile than a fund that's spread among hundreds of stocks. Conversely, such a portfolio will also get more bang for its buck if its stocks work out. You may want to add a concentrated fund, one that owns fewer stocks or puts most of its assets in the top 10 or 20 stocks, to your portfolio.

In general, your core funds should probably be well diversified and more predictable. On the edges, though, a sector-oriented fund, a more-flexible fund, or a more-concentrated fund could boost your returns.

Assess Performance Appropriately
Morningstar is known for its star ratings, which measure how a fund has performed historically, adjusted for volatility. It's not a subjective rating, and it's certainly not a buy or sell signal. It's a broad brush and compares funds in four broad assets classes: U.S.-stock funds, international funds, taxable bond funds, and tax-exempt bond funds. The star rating is best used when you are looking for a core fund in your portfolio.

Our category rating, though, is a finer cut. Still a historical performance measure, it compares funds only within their respective categories. It gives you a better idea of how a fund has stood up in a smaller group of peers. Remember, when you're looking at performance, be sure you're comparing apples and apples.

Be A Disciplined Investor
After you've chosen some funds, stick with them.

First, don't be afraid to go against the crowd. In a Morningstar FundInvestor study, we found that unpopular groups tend to outperform in subsequent years. In other words, small contrarian bets could be lucrative.

Second, discipline is key. Dollar-cost averaging, or investing a regular amount of money at regular intervals, tends to add value. For all U.S.-stock funds, we calculated hypothetical dollar-cost-averaging returns and compared them to the actual returns a dollar in those funds earned. For every category, the dollar-cost-averaging method won.

Know How Much You're Paying
If you know anything about Morningstar, you know that we're sticklers for low expenses. And generally, it's better to pay less than it is to pay more. But we found that expenses are more important when considering larger-cap, lower-risk funds, and less critical with small-cap funds and other higher-risk categories. For example, be wary of high expenses when you are considering bond funds. It's okay to be more tolerant of expenses for small-cap growth funds and emerging-markets funds, though.

Finally, a little about taxes. In taxable accounts, they represent a cost. To help you get a handle on this cost, examine the source of a fund's returns. Generally, bond funds, which usually pay regular dividends, are tax trouble, as are utilities funds. Also, check out a fund's capital gains. If a fund pays out large capital gains year in and year out, this may be a fund to put in a tax-deferred account.

You're On Your Way
Surely, there are many more nuances to investing, whether it be in mutual funds, stocks, or bonds. But just by following these basic guidelines you will be a smarter investor, you will be more likely to reach your goals, and in no time, you'll be off doing what you really want to do.