How to Get Rich(er) Ch. 2
Mutual Funds
Last time I wrote about the different types of investment vehicles. Now I will discuss the best way for us non-experts to invest. Mutual Funds consist of money from many different individuals. Many brokerage firms (Fidelity, Charles Schwab, etc) take your money and invest it according to a pre-determined strategy outlined in a fund prospectus. These funds can invest in stocks, bonds, money markets, or a combination of the three. Furthermore, a mutual fund can take your money and index the general stock market (S&P 500, Russel 2000 Index, Lehman Bros. Bond Index, etc), or it can actively attempt to beat the market through exceptional analysis and understanding of the market.
All funds charge an annual expense load in return for investing your money. The amount of the expense load is determined both by competitive forces as well as the amount of time necessary to maintain the fund. An index fund requires much less management, so the expense fees are significantly lower than actively managed funds. You should pay close attention to the expense load charged with any fund you purchase.
Index funds are hugely popular because it is very difficult for an actively managed fund to beat the stock market for an extensive period of time. Furthermore, an index fund may only charge you a 0.1% annual expense load and an actively managed fund might charge closer to 1% per year. The actively managed fund must beat the general stock market by 0.9% per year just to leave you in the same financial position. Usually, actively managed funds that beat the market by taking on additional risk. This means that the actively managed funds will significantly under perform when the market returns are weak. About 75% of actively managed funds fail to beat their respective index, so if you don’t think you can pick a winning fund, stick with the index funds.
Actively managed funds come in all shapes and sizes. As I said before, you can select funds that are generally consistent with the overall stock market. You can also select funds that specialize in small cap, mid-cap, or large cap stocks. As I indicated last time, small cap stocks tend to average better returns in the long run, but they are much more volatile in the short-term. Some mutual funds also target riskier stocks (perhaps companies with a high debt load). Other funds may focus on international stocks (of all sizes). You could select a fund that targets a specific industry (auto companies, financial services, energy stocks, etc). Furthermore, you can select mutual funds that target a specific section of the bond market (government bonds, investment grade bonds, high yield/junk bonds). You have many options!!
Mutual funds are a great way to diversify within a specific section of the market where you wish to invest. You can still target a certain sector of the market, but you can let an expert select the appropriate stocks or bonds instead of trying to do it yourself. You also can diversify much better since it is inefficient to purchase a few shares of individual stocks because of the commissions your brokerage firm will charge you.
One area of concern with mutual funds is the amount of assets under management. If a fund gets too large, it loses a lot of flexibility and ultimately loses its ability to beat the market over the long term. Fidelity’s Magellan Fund is a perfect example of this. The fund outperformed for many years and gained a lot of popularity from individual investors. They all dumped their money into this mutual fund and the fund got too large and is now a poorly performing fund that can’t beat its index. A couple of the funds that I have held for many years are victims of their own size. I did not pay enough attention to these old funds until this year, so I experiences sub-par returns for a few years. I am currently in the process of dumping these funds and buying similar, but more flexible mutual funds. Many brokerage companies close funds to new investors once the assets get too large. What constitutes “too large” depends on the investment strategy. A fund that invests in large cap stocks can afford to be significantly larger than a fund investing in small stocks and still be quite effective. Fidelity’s Contrafund has about $60 billion in assets and is doing very well, where Fidelity has closed other mutual funds to new investors when assets exceed $2 billion. If you haven’t figured out already, most of my money is invested through Fidelity. I don’t have a good reason for this other than this is where my dad opened up my college fund account many years ago.
I strongly encourage people in my age bracket to invest through mutual funds unless you have a solid understanding of the market or significant savings that allow to you take on more isolated risks from time to time.
My next post will focus on a good strategy for investing your money based on the size of your savings, as well as how to treat your 401(k) and Roth IRA differently from your taxable account. I’ll try to keep it as simple as possible since there are many different ways to invest your money based on your near and long-term needs for your savings. I’ll provide a little more color about what I am doing as well, even though I don’t necessarily think I have the perfect answer.
Last time I wrote about the different types of investment vehicles. Now I will discuss the best way for us non-experts to invest. Mutual Funds consist of money from many different individuals. Many brokerage firms (Fidelity, Charles Schwab, etc) take your money and invest it according to a pre-determined strategy outlined in a fund prospectus. These funds can invest in stocks, bonds, money markets, or a combination of the three. Furthermore, a mutual fund can take your money and index the general stock market (S&P 500, Russel 2000 Index, Lehman Bros. Bond Index, etc), or it can actively attempt to beat the market through exceptional analysis and understanding of the market.
All funds charge an annual expense load in return for investing your money. The amount of the expense load is determined both by competitive forces as well as the amount of time necessary to maintain the fund. An index fund requires much less management, so the expense fees are significantly lower than actively managed funds. You should pay close attention to the expense load charged with any fund you purchase.
Index funds are hugely popular because it is very difficult for an actively managed fund to beat the stock market for an extensive period of time. Furthermore, an index fund may only charge you a 0.1% annual expense load and an actively managed fund might charge closer to 1% per year. The actively managed fund must beat the general stock market by 0.9% per year just to leave you in the same financial position. Usually, actively managed funds that beat the market by taking on additional risk. This means that the actively managed funds will significantly under perform when the market returns are weak. About 75% of actively managed funds fail to beat their respective index, so if you don’t think you can pick a winning fund, stick with the index funds.
Actively managed funds come in all shapes and sizes. As I said before, you can select funds that are generally consistent with the overall stock market. You can also select funds that specialize in small cap, mid-cap, or large cap stocks. As I indicated last time, small cap stocks tend to average better returns in the long run, but they are much more volatile in the short-term. Some mutual funds also target riskier stocks (perhaps companies with a high debt load). Other funds may focus on international stocks (of all sizes). You could select a fund that targets a specific industry (auto companies, financial services, energy stocks, etc). Furthermore, you can select mutual funds that target a specific section of the bond market (government bonds, investment grade bonds, high yield/junk bonds). You have many options!!
Mutual funds are a great way to diversify within a specific section of the market where you wish to invest. You can still target a certain sector of the market, but you can let an expert select the appropriate stocks or bonds instead of trying to do it yourself. You also can diversify much better since it is inefficient to purchase a few shares of individual stocks because of the commissions your brokerage firm will charge you.
One area of concern with mutual funds is the amount of assets under management. If a fund gets too large, it loses a lot of flexibility and ultimately loses its ability to beat the market over the long term. Fidelity’s Magellan Fund is a perfect example of this. The fund outperformed for many years and gained a lot of popularity from individual investors. They all dumped their money into this mutual fund and the fund got too large and is now a poorly performing fund that can’t beat its index. A couple of the funds that I have held for many years are victims of their own size. I did not pay enough attention to these old funds until this year, so I experiences sub-par returns for a few years. I am currently in the process of dumping these funds and buying similar, but more flexible mutual funds. Many brokerage companies close funds to new investors once the assets get too large. What constitutes “too large” depends on the investment strategy. A fund that invests in large cap stocks can afford to be significantly larger than a fund investing in small stocks and still be quite effective. Fidelity’s Contrafund has about $60 billion in assets and is doing very well, where Fidelity has closed other mutual funds to new investors when assets exceed $2 billion. If you haven’t figured out already, most of my money is invested through Fidelity. I don’t have a good reason for this other than this is where my dad opened up my college fund account many years ago.
I strongly encourage people in my age bracket to invest through mutual funds unless you have a solid understanding of the market or significant savings that allow to you take on more isolated risks from time to time.
My next post will focus on a good strategy for investing your money based on the size of your savings, as well as how to treat your 401(k) and Roth IRA differently from your taxable account. I’ll try to keep it as simple as possible since there are many different ways to invest your money based on your near and long-term needs for your savings. I’ll provide a little more color about what I am doing as well, even though I don’t necessarily think I have the perfect answer.
posted by GaryGinew at 9:43 AM
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