Mutual Funds
For the average small investor, mutual funds are often a better
way to go than a portfolio of stocks and bonds. If you are going to be
investing in the stock market and do not have the time or aptitude to
select individual securities and decide when to buy and when to sell,
you need to read this section.
If reading the chapters on investing has left you with your head
spinning, don’t give up. It is possible to invest very effectively in
stocks and bonds without having to research individual investments and
make a lot of decisions yourself. In fact, for most people, it is much
better for them to invest in the stock market and the bond market
through mutual funds than it is to make the investments directly.
 Investing in this ways brings with it several advantages that cannot be
overlooked. The advantages address many of the issues that were raised
in other chapters on investing. First and foremost, mutual funds bring
with them professional management. They are run by men and women who
understand the financial markets and who study them on a daily basis.
Almost every mutual fund has criteria that they apply to a universe of
stocks or bonds (or both) and those criteria help them identify stocks
that need to be added to the portfolio and stocks that need to be
removed from the portfolio. These professionals make the buy and sell
decisions and you own shares in the mutual fund rather than in a
company.
Other advantages include record keeping that will satisfy the reporting
requirements of the IRS when it is time to pay your taxes and lower per
unit transaction costs because of the size of the purchases that are
normally made by the mutual fund company.
Mutual funds, by their very nature, provide you with reduced risk
through diversification not only with dozens of stocks but also across
several industries. All of this works together to make mutual funds a
really excellent way for people to get started with investing. Given the
ease with which one can invest in mutual funds and the way that it can
grow over time without a lot of worry and action on your part, it really
is an excellent way to go.
As with most things, it rapidly gets more complicated, even when you are
investing in mutual funds. There are literally thousands of different
mutual funds and even if you decide that it is the way that you want to
go, you will need to make a decision about which mutual fund you want to
invest in. Early on you will encounter the fact that there are different
kinds of mutual funds and the first thing that you will need to do is
decide what general type of mutual fund you want to invest in.
All mutual funds incur costs and make money by charging you a small
percentage of the average daily balance. While this percentage serves to
reduce your return, it also serves to provide you with a way to invest
in the stock market or bond market in a way that would not be possible
otherwise. As a general rule, you should be paying about 1% for this
purpose. Some will have higher rates; some lower; but 1% is reasonable
for this purpose.
In addition to this fee, there are also additional fees that you need to
take a really close look at before you invest. A lot of funds are “load”
funds in that they charge a fee (paid to the company or the agent that
sold you the fund) in addition to the fee mentioned above. There are
different kinds of load funds and although the industry has standardized
to a great extend you need to be aware of the fees that will be charged
when you buy and when you sell. The other option is “no-load” funds that
do not charge a fee when you buy or sell but also leave a lot of the
work in deciding what kind of fund to invest in to you, the investor.
I would recommend that you invest exclusively in no-load funds and avoid
anything that charges a front-end load, a back-end load or even a 12b-1
fee. A 12b-1 fee is a type of fee assessed to help pay for the marketing
and selling of a fund.
TYPES OF MUTUAL FUNDS
Mutual funds tend to mirror the stock choices that you have in that
managers tend to gravitate towards a specific type of stock or bond.
Mutual funds, then, are often classified by the stated investment style
of the manager or by an examination of the stocks held by the mutual
fund. If a mutual fund holds primarily growth stocks and that is the
stated investment objective of the manager, then it is a growth fund.
Growth mutual funds invest primarily in growth stocks (hence the name).
Value funds will invest primarily in value stocks and income stock funds
will invest primarily in income stocks. You can refer to the chapter on
stocks for more information or search the web sites that are mentioned
to learn a lot more.
A couple of other types that you will encounter: Sector funds that limit
investments to a specific industry (rather than diversifying across
several industries) and International funds that invest in stocks issued
by companies that are headquartered and doing business in other
countries besides the United States.
There are also mutual funds that invest in corporate bonds and
government securities. For a more complete discussion of this type of
investment, read the chapter on bonds and visit the web sites listed at
the end of that chapter.
Finally, there are Balanced Funds, which typically provide some degree
of diversification by investing in stocks and bonds for you. They
provide a mix of each type of investment and while the performance will
not be as good with this type of mutual fund as with a stock mutual fund
(over the long term), you will have less volatility than with other
mutual funds.
Cutting across all of these different kinds of mutual funds are socially
conscience mutual funds. They provide an additional set of criteria to
all of the types of funds mentioned above that screen for a whole host
of issues that may be important to you. Some of the screens may have to
do with hiring practices and benefits. Others may screen for the
environmental record or the ways in which the corporation in question
contributes to various causes. Still others may screen for the actual
product or service and avoid companies that provide products or services
that they find troubling. For example they may screen companies that
produce tobacco products or alcoholic beverages because of their
objection to the use of those items.
Different socially conscious funds apply different criteria and if you
choose to invest in this way you can make money, but be aware of what is
being screened. Not everything that is screened will be objectionable to
you. In fact they may screen for some things that you would rather be
invested in.
The first step when you have decided the basic type of fund that you
would like to invest in is to decide on the actual fund. You will need
to have a prospectus sent to you so that you will understand the nature
of the investment that you are about to put your money in to. A
prospectus is a legal document that provides a detail financial
background of an investment. This is required by the Security and
Exchange Commission and protects you from false statements that mutual
fund companies make from time to time. They must follow the terms laid
out in the prospectus and failure to do this gives you legal recourse
should you suffer a loss.
Start your search for mutual funds and mutual fund companies in one of
two ways. The first method would be to pick up a copy of Kiplingers
magazine or Money magazine and spend some time looking through the ads
that are found there. Virtually all of them will have toll-free numbers
for you to call and/or websites. You can then find information on fee
structure, management, investment policy and all of the things that you
need to know in order to make a decision about which fund you would like
to invest in. As you become more experienced and spend a little bit of
time each month reviewing how your investments have done, you will gain
the experience needed to select future investments that match up with
your financial goals and philosophy.
One of the ways to invest is through “dollar cost averaging”. This
simply means that you invest the same amount each month at about the
same time. You will find that in months where the market is down, you
buy more shares than when the market is up and over time your investment
grows faster because of the fluctuations in the market. It won’t give
you anything to brag about with your friends but it will help you reach
your financial goals faster than if you are constantly chasing the next
hot stock.
You will need to monitor your investments and that will be covered in
the chapter on asset allocation. You will also need to have in place
some general idea of when it is time to sell a fund that maybe is not
performing as well as hoped. If your fund is significantly under
performing the market, sell it and invest immediately in a fund that you
have researched that you think will do better. If the manager changes or
there is a significant change in their investment philosophy, it is time
to move into a fund that you are more comfortable with. The process as
this point is very similar to what is stated above in selecting the
first fund that you invest in.
Exchange Traded Funds (ETF)
This is a relative newcomer to the investment scene but may play a
role in your investment portfolio. It is somewhat like the sector mutual
funds mentioned earlier but instead of buying and selling within a
particular financial sector, an ETF buys a specific group of stocks and
holds them for the long term. When you buy a share of an ETF you are
buying a share in that specific portfolio of stocks. You get some
diversification (within that sector) and professional management but not
the wider diversification that you will really need for your
investments. If you go with ETFs you will need to be proactive and
diversify through other ETFs, mutual funds or other stocks.
WEB SITES:
http://www.usaaedfoundation.org/financial/bi06.asp
http://www.mutualfundsnet.com/v2/index.shtml
http://mutualfunds.about.com/cs/noload/a/spotloaded.htm
http://mutualfunds.about.com/od/mutualfunds101/
http://www.mfea.com/
http://www.sec.gov/investor/pubs/inwsmf.htm
http://www.fool.com/mutualfunds/mutualfunds01.htm
http://www.investopedia.com/categories/mutualfunds.asp
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