Most of us wouldn't buy a new home just because it looked good from the outside. We would do a thorough walk-through first. We'd examine the furnace. We'd check for a leaky roof. We'd look for cracks in the foundation.
Mutual fund investing requires the same careful investigation. You need to do more than give a fund a surface-level once-over before investing in it. Knowing that the fund has been a good risk-adjusted performer for investors in the past isn't enough to merit a financial commitment from you today. You need to understand what's inside the fund's portfolio now or how it invests.
Such information, which tells you how your fund will likely behave, helps you set realistic expectations. A fund manager who quickly buys and sells a compact portfolio of high-priced, fast-growing companies will produce different results from a manager who owns 300 stocks of larger companies with lower earnings but cheap prices. Further, unless you know what a fund owns, you can't determine what role the fund fills in your portfolio. For a fund to fill the large-cap growth portion of your portfolio, you need to know that it actually invests in large-growth companies. Finally, examining a fund's portfolio can tip you off to risks the fund may be harboring risks that might not have surfaced yet.
For U.S. stock funds, you'll want to know a handful of things, starting with the size of the companies in which the fund invests, as well as how much the manager is willing to pay for these companies and how quickly they're growing. A quick way to identify the relative size and characteristics of the stocks a fund owns is the Morningstar style box, which appears on the Morningstar fund report.
The Style Box Defined >>