How to Avoid 5 Costly Mutual Fund Buying Mistakes

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With over 10,000 mutual funds, when you go to buy a mutual fund, where do you start?

Start by learning what NOT to do. You’ll keep more after tax income when you avoid these five mistakes when buying mutual funds.

Mistake #1: Chasing the Stars

Pop finance magazine have to sell magazines, and headlines like “Top Ten Funds to Own This Year” sell. But do they make you money?

Morningstar, a company that does research on mutual funds notes that the single biggest predictor of top performing funds was not their own rating system of assigning stars, but the fund’s fees. Lower fees directly correlate with higher performing funds. Index funds have the lowest fees. Don’t buy high fee funds. Those fees are lining someone else’s pocket; not yours.

Mistake #2: Buying Funds With Embedded Capital Gains

Suppose you buy a mutual fund in October. In December that mutual fund sells a stock it has owned for ten years. A pro rata portion of that gain is then distributed to all current shareholders of the mutual fund. So now you are paying taxes on a gain that occurred within a fund that you have owned for only a short time. As a matter of fact, your shares may be worth less than what you paid for them, yet you will still be responsible for paying taxes on a portion of this capital gain.

When buying mutual funds in a non retirement account, you can avoid embedded capital gains by buying tax managed funds. index funds or ETFs.

At the end of each year you can also harvest losses by realizing a capital loss for tax reasons by exchanging one mutual fund for another similar fund.

Mistake #3: Eating Pork, Beef and Chicken

Many people own eight to ten different mutual funds and think they are diversified, but when you look inside the mutual funds, all the funds own the same type of stock, or the same type of bond. This would be like sitting down to a well balanced meal of pork, beef and chicken.

Before you buy a mutual fund, look under the hood. Does it own something different than other funds you own? If so, maybe it will be a good addition to your portfolio.

If you are buying mutual funds in your 401k check out 3 Foolproof Ways to Allocate Your 401k Money .

Mistake #4: Making Investment Income Become Taxed Like Earned Income

When you sell shares of a mutual fund that you have owned for at least 12 months, and they are worth more than what you paid for them, the gain is taxed as a capital gain. You pay taxes on capital gains at a lower tax rate than the rate charged on earned income and interest income.

However, if that capital gain is occurring in your retirement account, it doesn’t matter. Some day when you withdraw it, everything that comes out will be taxed at the same rate as earned income.

To reduce taxes you’ll want to decide which accounts to use to buy which types of mutual funds. Bond funds might be best suited for tax deferred retirement accounts, and stock index funds for non-retirement accounts.

Mistake #5: Using Actively Managed Funds Across the Board

Research shows low fee funds outperform their higher fee peers. Why is this? High fee funds typically take an actively managed approach. They pay a team of analysts and a fund manager to try to pick the best investments. Because the fund has to pay all of these people, the fees are higher. That would be fine, if the returns were also consistently higher, but they are not.

The winners one year are not the same winners the following year. This is why over time, a low fee fund which owns an entire category of investments rather than trying to pick and choose the “best” investments out of their category, has higher returns. A low fee index fund does not have to overcome the hurdle of higher fees for research and staff.