The Best Way to Invest in the Stock Market




Are trading fees important?

Trading fees are important when you trade often and make small investments. A good rule of thumb is to try to keep trading fees below 0.1% of your investment. This rule leads us to the following table:



Investment Size Kinds of investments
less than $10,000 mutual funds with no trading fees
between $10,000 and $100,000 mutual funds with no trading fees + ETFs
more than $100,000 no fee mutual funds + ETFs + fee mutual funds

 

Risk

Risk is an important consideration, when you invest in financial markets. Risk refers to the size of decline you might see in the value of your investment, when market conditions deteriorate. I will mention here two simple measures of risk:

Beta





One relatively simple way to estimate the risk of a mutual fund or ETF is through a quantity called ‘beta’ (after the second letter of the Greek alphabet). In somewhat simplified terms, beta compares the size of fluctuations of your mutual fund to the size of fluctuations of the stock market as a whole. In this way, a beta of 1 means that, on average, this fund has experienced fluctuations in value that are similar in size to those of the market as a whole; a beta of 2 means that, on average, this fund has had fluctuations in value that are twice as large as those of the market as a whole. A beta value smaller than 1 indicates that, on average, this fund has experienced fluctuations in its value that are smaller that the fluctuations of the stock market as a whole. Mind you, these are averages based on the past, and they may not hold true in any particular circumstance.




In brief, a larger value of beta implies a higher risk. I recommend to avoid mutual funds or ETFs with beta bigger than 1.5; try to stay close to beta of 1 or less in your portfolio. You can find the beta of a mutual fund listed on many financial websites, such as Morningstar.

Market lows

Another important way of assessing the risk of a particular mutual fund or ETF is to look at its behavior during periods of significant market declines (corrections or bear markets). I recommend against buying mutual funds or ETFs that dropped significantly more precipitously than the Standard and Poor’s 500 (SP500) index during notable market declines.

To be able to assess this aspect, avoid ‘new’ mutual funds or ETFs that have been around for less than three years. To check a fund’s behavior during market lows, simply compare the plot of its share price to that of the SP500 index over a period of a few years. You can do that on many financial websites, such as Yahoo finance. During lows, the fund shouldn’t drop much lower percentage-wise than the SP500.

Mutual fund families





Mutual funds usually come in ‘families’, where the term ‘family’ refers to the financial firm that issues the mutual fund. I recommend to avoid new mutual fund families, or mutual funds issued by small or new firms. Try to stick to mutual funds and ETFs issued by large and well established financial firms that have a solid track record. The financial firm issuing the fund should be a reliable investment house with a long history and no significant regulatory action against the company.

Holding time restrictions

Most mutual funds impose restrictions on frequent trading. That’s fine – we don’t plan to engage in too much trading, but trading is often necessary, when market conditions change. Frequent trading restrictions mean that the mutual fund will impose some sanctions on you, if you hold the fund for less than a specified minimal period of time. These sanction are sometime financial in the form of a redemption fee: a redemption fee is imposed, if you hold the fund for less than a specified minimal period of time. In other cases, these sanctions just prohibit you from re-investing in the fund for a month or two.

My recommendation is simple: avoid mutual funds for which the minimal holding period is longer than 30 days, if they impose a redemption fee.

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