Pitfalls to Avoid

Fundamentals of Market Investing by Adam J. McKee

Past Performance

A mutual fund’s or ETF’s past performance is not as important as one might think.  Advertisements, rankings, and ratings often emphasize how well a mutual fund or ETF has performed in the past.  However, studies show that the future is often (almost always) very different.  This year’s number one mutual fund or ETF can easily become next year’s below average mutual fund or ETF.  For mutual funds and ETFs, be sure to find out how long the fund has been in existence.

Newly created or small mutual funds or ETFs sometimes have excellent short-term performance records.  Because newly created mutual funds and ETFs may invest in only a small number of stocks, a few successful stocks can have a large impact on their performance.  However, as these mutual funds and ETFs grow larger and increase the number of stocks they own, each stock has less impact on performance.

In other words, it is difficult to sustain initial results.  While past performance does not necessarily predict future returns, it can tell an investor how volatile (or stable) a mutual fund or ETF has been over a period.  Generally, the more volatile a fund, the higher the investment risk.  If you need your money to meet a financial goal in the near-term, you probably can’t afford the risk of investing in a fund with a volatile history because you will not have enough time to ride out any declines in the stock market.  For index mutual funds and index ETFs, remember that these funds are designed to track a particular market index, and their past performance is related to how well that market index did.

Money Market Confusion

Do not confuse a money market fund with a money market deposit account.  The names are similar, but they are completely different.

A money market fund is a type of mutual fund.  It is not guaranteed or FDIC-insured.  When an investor buys shares in a money market fund, he or she should receive a prospectus.

A money market deposit account is a bank deposit.  It is guaranteed and FDIC-insured.  When a saver deposits money in a money market deposit account, he or she should receive a Truth in Savings form.

Don’t Trust the Name

Don’t assume that a mutual fund called the “ZYX Stock Fund” invests only in stocks or that the “Martian High-Yield Fund” invests only in the securities of companies headquartered on the planet Mars.  The SEC generally requires that any mutual fund or ETF with a name suggesting that it focuses on a particular type of investment must invest at least 80% of its assets in the type of investment suggested by its name.  Nevertheless, mutual funds and ETFs can still invest up to one-fifth of their holdings in other types of securities—including securities that a particular investor might consider too risky or perhaps not aggressive enough.

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