Mistakes (and Solutions) for the Fund Investor

Investor confusion is running rampant in the wake of unprecedented growth in the mutual fund industry, a recent government survey says.

Among the survey's more troubling findings: Roughly one in four investors thinks their mutual fund shares are federally insured. One out of every three thinks it's safer to buy a mutual fund from a bank than a broker. And one investor in six is convinced you can't lose money on a money market fund.

Despite the findings of the Securities and Exchange Commission survey of 1,000 investors, mutual fund shares have no federal insurance backing, and the safety of the investment has nothing to do with where it is purchased. It is also possible to lose part of your principal in a money market fund, although it rarely happens.

A great deal of the confusion is understandable, says Don Phillips, publisher of Morningstar Mutual Funds in Chicago. Not only are mutual funds increasingly catering to less sophisticated investors, but some basic fund information is purposefully complex and misleading, he says.

With fund balances growing by roughly $22 billion a month, knowing the common mistakes--and how to avoid them--could save investors a fortune.

Mistake: Believing everything you read.

For instance, fund directories often list mutual funds by category, with divisions for growth funds, income funds, international funds, etc.

However, funds are frequently mis-categorized--either innocently or on purpose, Phillips notes. For instance, Morningstar recently analyzed the holdings of a variety of funds and found that Fidelity Capital Appreciation--a so-called aggressive-growth fund--was 40% invested in international holdings. Meanwhile, Janus Worldwide--an "international" fund--had only 20% of its portfolio invested internationally.

If you wanted to shift investments from growth stocks to international stocks, your logical inclination would be to sell Fidelity Capital Appreciation and buy Janus Worldwide. But, in fact, you'd be doing the opposite of what you'd planned.

Some fund-offering documents also misstate what the fund will be doing, simply to leave the fund manager's options open, Phillips says. One fund prospectus--a legal document given to fund investors--devoted six pages to explaining complicated risk-hedging techniques the fund could employ, for example. But the fund manager said he had no interest in "hedges." The information was only there because the fund's attorneys thought it ought to be an option.

Solution: Check your local library for Morningstar Mutual Funds' directory, which examines what the fund is rather than what it says it is.

Mistake: Confusing "average annual returns" with annual returns. Fund companies frequently disclose their average annual return over long periods, and that can be helpful to someone who has a long-term investment horizon. But averages mask volatility--the up and down swings. And volatility can be pivotal, particularly if you have a relatively short investment horizon.

Say, for example, that John Smith is investing $10,000 for five years and he's looking at both Fund X and Fund Y. Fund X has a 12.5% average annual return over the past 10 years. Fund Y has returned just 10%. Which should he choose? To get the answer, he looks at actual annual returns and finds that Fund Y has consistently posted returns ranging between 9% and 11% and has a relatively conservative philosophy that reduces the chance of a major loss. Fund X, on the other hand, takes chances and has the track record to prove it. Its annual returns have varied between gains of 80% and 45% drops. Since Smith doesn't have enough time to ride out market swings, he chooses Fund Y.

Solution: Do your homework, getting both average annual returns and actual annual returns to see which individual fund provides you with the greatest return for the smallest amount of risk.

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