So after all these information, how to we actually evaluate the best mutual funds? Is 15% year after year a good amount? How do we know if the fund is poised for more growth? These are some of the questions an investor will face.
Previously, we have mentioned that it is important to look at historical data. This means that a fund might be able to perform extremely well in one year but poorly in the next. When we want to access the performance of a mutual fund, we always even out these percentages and pick one that is most reflective of its true return.
The question is how do we know if this number is great or not?
This is where we start to use a certain “benchmark” to assess the performance of funds. To better illustrate this, imagine if you are taking an academic test with a class of 30 students. When the result comes back to you, you discovered that your score is 65/100. Well, that looks like a pretty average score in a vacuum. However, when you discovered that the class average score if only 45/100, your score suddenly becomes very impressive! Your result has been compared to a benchmark that is the class average.
The same can be said of mutual funds. The benchmark is how the entire market is performing. If the entire market has returned 50% in the 1 year time period, your fund’s 15% return is absolutely miserable relatively. However, if the market has declined in that 1 year period, your fund has done a stellar job. Here are some commonly used benchmarks that are used:
– S&P 500 Index
– Russell 2000 Index
– DJ Wilshire 5000 Index
– Dow Jone Industrial Average
Besides comparing to the benchmark that is the market, you can also compare its performance against its peer group. If other funds that invest with a similar mandate managed to produce similar performance, then we know that the fund we invested in is only performing in line with expectations. Of course, this is a fairly simplistic, but adequate view of assessing performance. In reality, you might want to plot as many data points as possible and take a deep dive into validating the performance data you have sourced from the web.