In the last lesson, you learned about how to become a better investor by learning about alternative investments. – from farmland to wine. Today, we are going to drill down even further and learn about mutual funds, how they work, and how you can start investing intelligently with them!
Everyone seems to have their own opinion about how to create wealth. Some of these “experts” may be the broke uncle who just found the next hot stock to invest in. Other “experts” are insurance companies that are selling a product like an annuity or a pyramid scheme that may or may not be suitable for you. Even others talk about mutual funds. With all of this information and misinformation, where do you start?
Today we are focusing on mutual funds and everything you need to know to create wealth by using them. I will also show you the mutual funds I regularly buy and how I have been able to increase my retirement account to be worth 89% more than what I have paid into it. I was able to do this even while investing before and through the financial recession in 2008.
We will focus on:
- What are mutual funds?
- The different types of mutual funds
- The most important details to consider before buying a mutual fund
- The pros and cons of investing in mutual funds
- Deciding which fund is right for you and how you can start investing today
Mutual Fund Basics
By now, you should be fully aware of the concept of individual stocks. This lesson is going to show you how to take individual stocks and invest in a large number of them at once. This is referred to as diversification.
A mutual fund is a way for people to invest in several companies by purchasing only one product – namely, a mutual fund. A mutual fund is one individual fund made up of many different investments, such as stocks, bonds, money markets, and others.
The single mutual fund is overseen and managed by a group of money managers who make decisions about what individual investments should make up the overall fund. Also, each fund has a general direction and goal that is detailed in its operations manual, known as a prospectus.
The prospectus will define what types of investments the money managers will purchase and the overall investment strategy. For instance, a mutual fund may focus on creating wealth by investing in:
- Large-cap stocks
- Mid-cap stocks
- Small-cap stocks
- Government Bonds
- Municipal Bonds
- Corporate Bonds
Mutual Fund Goals And Focus
The overall objective of a mutual fund, detailed in the prospectus, often follows a specific strategy. These strategies are described as:
Growth Stock Funds
Money managers who manage mutual funds based on growth stock funds invest in companies they expect will grow faster than the average market returns. This involves research and buying company stock believed to increase at a faster pace than others and to sell other company stock that has slowed or is predicted to slow down.
Value Stock Funds
When you think of value stocks, think of items in a “bargain bin.” These are stocks that the portfolio (money) managers believe are being sold at a discounted price but are worth more than the amount they are being sold.
Blend Stock Funds
Blend stock funds invest in a “blended” mixture of both growth and value stocks. These types of funds attempt to diversify and mitigate significant losses by sacrificing substantial returns. By balancing value and growth, the goal is to maintain a steady momentum of making money at a modest rate.
The strategy of index mutual funds is to mirror a market index. If a company drops out of an index, the money managers do the same and cut the company from the mutual fund portfolio. Also, each company holds a different weight within an index. Index funds also weight these companies the same way within the mutual fund.
Common market indexes that mutual funds mirror:
- Russell 2000
- 2000 small-cap companies
- Wilshire 5000 Total Market Index
- Overall U.S. company equity index
- Standard & Poor’s 500 Index
- Top 500 U.S. companies
- MSCI EAFE
- Foreign companies from Europe, Australia, and the Far East
- Barclays Capital U.S. Aggregate Bond Index
- Follows the total bond market
- Nasdaq Composite
- Follows the 3,000 companies listed on the Nasdaq market
- Dow Jones Industrial Average
- Follows 30 of the largest companies in the market
Pros And Cons Of Mutual Funds
Investing in mutual funds has its perks, but they also have their drawbacks. Consider these points before you decide to start investing in mutual funds.
The Pros Of Investing In Mutual Funds
Investing in individual stocks can be risky. By owning a single stock, you are at the mercy of how well the company does and the decisions made by management. If the company reports a loss, your stock and all of your assets invested in that company may fall. If the company increases productivity and revenue, your investment will follow suit.
With mutual funds, you can invest in many different companies all at once. In theory, if one company declines, another will gain, which will lessen the impact of a drop in revenue. By spreading out your risk by investing in a group of companies, you are more likely to see more stable income growth with less risk.
In other words, mutual funds agree with the phrase, “don’t put all your eggs in one basket.”
Professional Money Managers
Each mutual fund has a team of money managers that conduct ongoing research and make educated predictions of a company. Rather than relying on your gut instinct on which company you should invest with, these portfolio managers spend all of their time researching and forecasting future trends.
By investing with mutual funds, you no longer need to worry about staying up on market trends – this is all done for you. If you choose to invest in index funds, you can essentially “set it and forget it.”
The Cons Of Investing In Mutual Funds
By far, the #1 issue of investing in mutual funds is the fee you will pay to have someone else manage your money. These can be in the form of a one-time front end or back end fee or an ongoing annual fee. There is not one standard fee, but instead, each fund can implement whatever fee they deem necessary. Also, many mutual fund managers attempt to hide these fees by referring to them with unfamiliar terms such as:
- Sales Load
- Expense Ratio
- 12b-1 Fee
- Other Expenses
Depending on the fund, you may be charged as little as 0.04%(index funds) up to 2.5% (actively managed funds) annually. Front end load fees can also range up to 5% of your initial investment as a fee.
While a 2.5% annual fee may not seem high, the difference between .04% and 2.5% over 10+ years can mean ten to hundreds of thousands of dollars you would be handing over to the investment company that could have been in your pocket.
Lack Of Control
While you do have control over which fund you invest in, you do not have control over which companies are bought and sold within the fund. Some people are comfortable with this arrangement while others want need more control over their investments.
Index Funds VS. Actively Managed Funds
As stated before, index funds track the market. If the overall market goes up, so do the investments in index funds. If the market goes down? You guessed it, so does the fund’s value.
Actively managed funds attempt to “beat the market” by trying to predict which stocks will do better in the future and which ones need to be sold to avoid a loss. These actively managed funds incur more fees due to the active buying and selling that occurs inside the fund.
So which is better? Index funds or actively managed funds?
The Winner is……Index Funds!
It’s true; index funds will generally make you more money than an actively managed mutual fund. Index funds also have the lower fees of the two – so why would anyone buy an actively managed fund? They buy actively managed funds because they believe all the false and misleading information that the mutual fund industry throws at them.
First, let’s drill down into the data to back up my assertion that index funds are superior.
Mutual Fund Games And Misleading Information
According to a report by Market Watch, If you look over the past 15 years, only 34.11% of large-cap actively managed mutual funds are still around. That means that if you go back over the past 15 years, 65.89% of large-cap actively managed mutual funds performed so poorly they had to scrap the fund.
By eliminating these funds, they keep only the top performers who make the industry as a whole look better. It’s like throwing a bunch of stuff at the wall and seeing what sticks. When something sticks, you point to that and tout it as being successful by ignoring all the other failures that fell.
For this example, let’s ignore the 65.89% of the funds that are no longer around and focus in on the 34.11% of funds that were the top performers. According to a research report from Standard & Poor, over the same 15 years, 92.2% of these large-cap actively managed funds did not outperform the market.
What does this mean?
Quite simply, out of the best performing actively managed mutual funds, only 7.8% of them were able to outperform the market over 15 years. In other words, if you factor in all of the mutual funds, you have a 1 in 20 chance of picking a fund that will outperform the market for any length of time.
If that doesn’t scare you, the opposite is true. You have a 19 in 20 chance of picking a fund that will not beat the market – and may perform so terribly your initial investment may sink like a rock. I don’t know about you, but I’m not risking my hard-earned money on an actively managed fund “hoping” to equal or beat the market.
Warren Buffett’s Index Fund 1 Million Dollar Bet
To further drill in the index fund point, I want to draw your attention to a unique bet Warren Buffett made with the hedge fund industry, specifically Protege Partners LLC, who accepted the bet.
The bet involved one million dollars. The winner would donate the winnings to a charity of their choice. Warren Buffet bet the hedge fund industry that an index fund would outperform their most expensive and best actively managed mutual funds over a 10-year time frame.
Protege Partners LLC chose five separate funds (which were not disclosed), and Buffett chose the Vanguard S&P 500 Admiral Fund.
The competition initially began on January 1, 2008. 2008 should ring a bell because that is when the stock market tanked. In year 1, Buffett’s index fund lost 37% of its overall value, while Protege only lost 23.9%. While this certainly was a bad start for Buffett, it certainly was not a predictor of the future.
One year later, Buffett recovered and beat Protege’s returns every year from 2009 to 2014. 2015 was another loss for Buffett by only recording a return of 1.4% vs. Protege’s 1.7%. However, 2016 put the nail in the coffin of Protege when Buffet again pummeled the actively managed fund by posting a return of 11.9% versus 0.9%.
With the close of 2016, the index fund had averaged 7.1% yearly returns, while the more expensive and actively managed funds averaged only 2.2% each year. Due to the severe beating, Protege quit the competition early and admitted defeat to Buffett’s index fund.
How To Invest With Mutual Funds
Now that we have a good handle on how mutual funds work and how the various types perform, it’s time to take actionable steps to invest with mutual funds.
Step 1 – Check With Your Employer
Usually, the best option is to contact your employer and learn about any retirement plans offered to you. Most employers have some type of employer-sponsored retirement plan that usually has a few mutual fund selections to choose from. Pay attention to the expense ratios of the funds and how long they have been in inception.
Option 2 – Invest With A Broker
If you have a funded employment retirement account, you can also make additional investments outside of your retirement plan. If you have extra cash lying around from selling a bunch of stuff, you can open a brokerage account at TD Ameritrade or E*Trade to gain access to mutual funds.
You simply fund your TD Ameritrade or E*Trade account with funds and invest in the mutual fund of your choice.
My wife and I put our six-month emergency fund in mutual funds but keep our regular emergency savings in cash. By using these platforms, you can usually access your money in just a few days if you run into a long term emergency that requires the use of your 3-6 month emergency savings.
Wrapping It Up With Actionable Steps
To start creating wealth, check with your employer, and any retirement options available. If you have more money set aside, investing in index mutual funds by using a cheap brokerage firm like TD Ameritrade or E*Trade is an excellent way to start making your money work for you!
This mutual fund lesson should have you well equipped to start investing in one fund that uses diversification to reduce risk. Tomorrow you will learn about Exchange-Traded Funds (ETFs).
You will learn the similarities and differences they have to mutual funds, the pros, cons, and fees you can expect to pay when trading with ETFs!