Is a Morningstar fund analyst really telling you that other issues are more important to consider than deciding which fund to own? Yes.
Many investors spend too much time thinking about individual funds and too little time thinking about more important investment questions such as their goals and overall asset allocation. Two such issues should take precedence over the consideration of specific funds. Only after you've addressed them should you begin thinking about which funds are appropriate.
Know your goal
Before coming to Morningstar I worked as a financial adviser, and I was
amazed by how many clients just "wanted to make money" but couldn't
articulate a specific goal for the money they were investing.
My clients weren't completely off base. Having and making more money is clearly better than having and making less, or losing money. But people have specific financial goals to meet. Some of the most common are paying for their children's educations, owning a home, and providing for retirement. A simple desire to have and make more money without thinking about its specific purpose can get you into a heap of trouble.
A big challenge is that different goals require different time horizons. An area offering the potential for high gains can be the right choice in some cases but not others. In retrospect, a high-yield bond or emerging-markets fund clearly would have been great to own in 2009, as the Merrill Lynch High Yield Master II Index and the MSCI Emerging Markets Index have gained 57% and 77%, respectively, for the year to date through December 28. But they wouldn't have been appropriate places for money that an investor planned to use to buy a home in the middle of 2010 or for the entire allocation of your child's schooling fund, out of which the first tuition payment is due next September. Big near-term losses are just too common in these asset classes. For example, if one had to meet those goals in 2008 or early 2009, the results could have been catastrophic; those same indices plummeted 26% and 53%, respectively, in 2008. And there was no guarantee that those asset classes would bounce back so well in 2009.
The appropriate place for money that you'll spend within two years is in cash in the form, for example, of a money-market fund. For a time horizon of two to three years, you can consider a conservative short-term bond fund or an ultrashort bond fund. Anything else is too risky. Then you must be prepared to see the return on that investment lag many other choices. In fact, it's virtually guaranteed that some asset class or sector funds will dramatically outperform that money-market account safeguarding next year's tuition payment or down payment for a house. Learn to live with the fact that returns on short-term money may look weak next to alternatives.
In short, getting the best possible returns on that money isn't the point; protecting it from loss is more important. Certainty comes at a price.
Understand market history
Over the long haul, equities have been better performers than money
markets and short-term bond funds, but they're no panacea. Knowing
market history can help you build a successful long-term portfolio that
neither overdoses on equities nor avoids them altogether.
Equities have returned about 10% annually for nearly a century, but they can go through extended periods of very poor performance. For example, the FTSE 100 index may have gained over 20% during 2009 but it has also posted a cumulative loss of 21% for this decade to December 31, 2009.
The immediate future is unclear. It's encouraging that equities are not as expensive now as they were at the start of this decade, when many top companies were trading at P/E ratios of 30 or more. Still, it's difficult to know whether the market's current valuation is artificially inflated or depressed because it's not clear if underlying corporate earnings are representative of future levels.
Because uncertainties like this almost always exist, Benjamin Graham thought a 50/50 equity/bond portfolio was a reasonable choice for most people's long-term money. Vanguard founder Jack Bogle, by contrast, prefers the formula indicating that your equity exposure should be 100 minus your age. Others ratchet Bogle's formula up to 110 minus your age for equity exposure. It doesn't matter too much which of these you use but that you pick one and stay with it, rebalancing diligently as the markets take your prearranged allocation out of whack.
Knowing which equities have returned over the longer haul, and knowing that they can disappoint over multidecade periods, can also help you keep saving appropriately. Don't count on a roaring stock market to bail you out of not having saved enough for retirement or another major financial goal. That way, if the next decade for equities turns out to be a great one, that will be icing on the cake.
