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The stock market's rally over the past year has made it easy to make money from your investments. But if you think it's always going to be that easy, think again. Going forward, you need to make sure that you find the best investments you possibly can.
So many answers
The obvious question, though, is how to find those great investments. With stocks, you'll find a multitude of answers. Some investors look for reasonably priced stocks that reward their shareholders with a regular flow of dividend income -- stocks like Procter & Gamble (NYSE: PG ) and PepsiCo (NYSE: PEP ) , for example, which not only have impressive current payouts but also have enjoyed double-digit annual growth in their dividends. For others, the ideal stock may be a pioneer in its industry, such as Google (Nasdaq: GOOG ) or Green Mountain Coffee Roasters (Nasdaq: GMCR ) , whose businesses have brought new angles to existing markets. Those or many other methods will uncover a multitude of promising stocks.
All sorts of different stocks enjoy success. But when it comes to mutual funds, you'll find that most winning funds share many of the same traits. Here's what you should look for to make better choices among funds.
1. Keep it cheap.
It sounds obvious, but it bears repeating: The more you pay to invest in a mutual fund, the less profit you'll have left to keep. One reason why index funds and ETFs have gotten so popular is that they give you the investments you want at the lowest possible price -- as long as you avoid unnecessarily expensive ones.
Obviously, some actively managed funds will succeed in overcoming their higher cost structures to beat the market. But those costs are something an active manager has to offset year in and year out. Over the long haul, it's important even for active funds to keep their costs as low as possible, so that the headwinds they face won't blow your money away.
2. Watch the turnover.
Another measure of a successful fund comes from its turnover ratio, which refers to how much of a fund's portfolio the manager trades each year. Whereas index funds or managers who follow a long-term investment philosophy might have turnover ratios of 10% or less, hyperactive high-activity funds often see turnover of 100% or more.
High turnover does two things. First, it increases the internal transaction costs of the fund, which costs you in performance. Second, it makes more of your gains subject to short-term capital gains tax. For example, if your fund manager bought shares of Ford Motor (NYSE: F ) or Bank of America (NYSE: BAC ) last March, you had to be happy with the multibagger performance each gave you. But if the manager sold those shares for a quick profit, you got hit with a tax bill of up to 35% -- 20% of which you wouldn't have had to pay if your manager hadn't had quite as itchy a trigger finger.
3. Know your manager.
With thousands of mutual funds to choose from, there's no substitute for experience. You don't need to be the guinea pig for an untested new fund manager. By using only those managers with proven track records, you'll know what to expect and can have more confidence in the way your money is being invested.
Sure, you'll miss out on some extraordinary talent that way. But typically, you'll have more than enough time to get in on a good manager later. The money you save avoiding those managers who never succeed should more than make up for the times you're late to catch a winner.
4. Demand accountability every year.
Too many fund investors make smart picks initially but then fail to follow through. Even the best money managers have down years, so you shouldn't dump them the first time they lose money for you -- but you should demand an explanation that satisfies you.
For example, Bill Miller's track record as head of Legg Mason's Value Trust was extraordinary until 2007 and 2008. Although many criticized Miller for investing in financials during the market meltdown, his fund rebounded in 2009. You'll still find financials like Goldman Sachs (NYSE: GS ) among his holdings. If you accepted Miller's explanation and held through the tough times, you earned a fair amount of your money back.
Even if you do everything right, you should expect to see losses in your portfolio from time to time. But by staying smart about how to choose the right stocks and funds, you'll make better investments -- and over the long run, they'll pay off for you.
Don't settle for mediocre profits from your investments. Joe Magyer wants to know why you aren't earning 50% annual returns -- and will show you where you might find them.