Although the dramatic decline in the financial markets is frightening, stocks are a lot cheaper now than they have been in the recent past. That means it's as important as ever for long-term investors to have stock market exposure and to pick stock mutual funds wisely. Because there are now more than 8,000 mutual funds, the ability to figure out quickly which ones are worth detailed examination is crucial. Let's go through our 10-minute test for mutual funds to help you narrow your focus.
A caveat before we start: Many of the rules I list have exceptions. However, if you apply these shortcuts, you'll significantly increase your chances of eliminating the duds.
Examine What the Fund Owns
You should have an idea of what you want your asset allocation to be--how much money you want in stocks and bonds--before you start looking at funds. If you're looking at a stock fund, ask whether it owns lots of big, recognizable companies, which can make it suitable as a core holding. Or is it a small-cap fund that owns businesses that you haven't yet heard of, making it a good candidate for a supporting player in a portfolio? Is the manager impressed with earnings growth, or is he or she more value-oriented, trying to buy stable earnings or assets at a deeply discounted price? If it's a bond fund, does it hold longer-term bonds whose prices may bounce around as interest rates move, or is a shorter-term fund that will remain steadier but typically pay you less interest? Use the Morningstar Style Box for stock and bond funds to understand what a particular fund does.