by John Markese

About the author

John Markese is the former president of AAII.

Rule #1: Understand what the fund invests in and the funds investment approach before you invest.

Sounds like common sense and simple, but not enough investors take the time to review a prospectus and an annual report.

First, read carefully the investment objective of the fund:

• Will the fund pursue growth in capital, emphasize income, or use a combined approach?
• Will the investment emphasis be on domestic or international stocks, or some combination?
• Will the fund be broadly diversifiedin the case of a stock fund, covering diverse industries and stock size categories (large-cap, mid-cap, small-cap)or will it be concentrated in a few industries?
• Will the manager be effectively fully invested at all times, or will some form of market timing be employed?

When it comes to bond funds, the same questions generally apply, but the spotlight should be placed on maturity, credit risk, yield and taxation. Also, keep in mind that the fixed-income world is much more complex than the stock world. Although stocks may vary in risk, the instruments are structured similarlya stock is a stock. However, there are many different types of fixed-income instruments, some of which can be complex and confusingthink collateralized debt obligations or auction rate preferreds.

ETFs vs. Mutual Funds

Exchange-traded funds (ETFs) are portfolios of securities that are usually passively managed and that track an index, offering an alternative to traditional index mutual funds. Although they are similar to traditional mutual funds in that they consist of a portfolio of securities, ETFs are listed on an exchange and trade just like an individual stock. This provides trading flexibility that does not exist with traditional index funds.

Most of the mutual fund rules discussed here are equally appropriate when building a portfolio of ETFs.

Why look carefully at the investment strategy and the actual investments in the fund? After all, its up to the portfolio manager to implement the approach and the actual investments have already changed by the time you have reviewed the annual report. Well, markets fall out of bed every once in awhile, and if you do not have a feel for how the portfolio is likely to behave in different market environments, you are likely to make poor long-term decisions in reaction to short-term market events.

And if you dont completely understand the portfolio strategy or the investments, what should you do? Run.

Rule #2. Before investing in a fund, determine the funds relative and absolute risk.

Return usually catches an investors eye and risk is often an afterthought or no thoughtuntil the market turns sharply down.

Funds tend to rise toward the top of performance lists because they either are managed differently from the other funds or simply take on more risk. And the managed differently approach usually also entails greater risks through concentrations in a few industries or investing in only a small number of stocks, or using leverage through futures and derivative products.

Risk by definition is variation in return over time. The greater the variation in return, the greater the risk. For mutual fund investors, time horizon brings the concept of risk into a practical perspective. A short time horizon combined with a high potential for variation in return is a mismatch. The suggestion that investment in stock funds should only be made if an investors time horizon is greater than five years is a practical realization of return variation and time.

Two common ways of capturing risk are the standard deviation and beta statistical measures.