The Basics – Mutual Fund Investing

 What is a mutual fund? For many of us one of the easiest ways to invest is through mutual funds in our employers 401k/403b retirement plan. These plans mostly allow your to invest in mutual funds, and so what are mutual funds? They are an investment vehicle that takes money from investors, which is you and I, and pools this money together to buy investments that are typically a mixture of stocks, bonds and cash. When you buy a mutual fund, you are buying shares of the fund that contains these investments. Nowadays there are plenty of different types of mutual funds to buy, which can differ in their strategy of investing

. If you are starting off, it is may be best to invest in an index fund, tracking the general stock market index. The reason for this is that the expense fees for owning this fund are incredibly low, since a computer that does not require a salary is automatically doing the investing. Moreover, it has been estimated that this indexing approach typically beats about 80% of mutual funds with active (human) management, with the low fees significantly aiding the performance of this index-based approach. 80% sounds like pretty good odds to me, so it is probably worth taking this approach.

What are the benefits of mutual fund investing?

When you buy a mutual fund you are more diversified than buying an individual stock, which can help protect potential downside losses (one stock can go to $0, but it’s unlikely that a whole bunch of stocks will). You can also still capture much of the upside, as stocks within a certain sector/industry, such social media, semiconductors, solar power, etc, will often move in the same direction together. Additionally, buying a mutual fund allows you to immediately buy a bunch of stocks but without paying the trading fees that you would otherwise pay for acquiring the stocks in each company individually. Also, when you buy a mutual fund, other than the index style of fund, you are essentially getting the help potential experts that manage the fund who have put in time and effort to maximize the returns of the fund. Here is a brief description I found made by Investopedia on how mutual funds allow you to be quickly diversified with limited funds:

What are the drawbacks of mutual fund investing?

If you want to get into more active forms of investing, you may find that mutual funds are quite limiting. When you buy the fund, you often have to hold it for a minimum number of days, such as 30 to 90 days, depending on the fund. If you need to sell the fund before this time is up (because the market is tanking, or you need cash quickly, etc) you will incur a penalty, such as a 1 or 2% of the amount involved to do so. Furthermore, the fund is sold at a specific time, such as 4pm, and is not traded like common stock or ETF, where you can sell immediately or put in stop loss limits or sell when it reaches a certain price, instead you just get the price at 4pm.

How do you buy a mutual fund?

You can buy a fund through online brokers or directly from the mutual fund company, and hold the fund in either a taxable or in a tax sheltered account, such as IRA, 401K, etc. There are multiple options to choose from, including funds available from Fidelity (large number of choices), Vanguard (renown for its low fees), T. Rowe Price (low monthly minimum investments), etc. Once you have set up your account, you then have to choose the type of mutual fund that you would like to invest in. It is common for beginners to choose index funds, but there is no shame in this, as discussed early, index funds can out perform most professional money managers in the long haul. However, if you want to become more specialized, you can often choose a wide variety of funds. For example, in my Fidelity 403b account I have the option to buy close to 300 Fidelity managed funds, in addition to over 2,000 further funds that are not managed by this company, so I certainly have plenty of options. When I want to invest in more than just index funds, next on my list are the sectors/industry funds, as some part of the market, whether the general market is going up or down, is always making money, and thus it’s great to try be in these right sectors/Industries that are making profits. For example, one of the hot sectors in 2013 was Biotech, with performance of the Biotech funds often at 50% or more, which is a truly substantial gain. There are various ways to find hot sectors, often with the aid of the mutual fund, brokerage account highlighting the recent and long-term performance of the sector. One of my favorite screens, which I wrote about early is to use Bill Gunderson’s Best Stocks Now app, as it provides me with an idea the value in addition to the performance of the fund.

What should you keep an eye on, when buying funds?

Other than the obvious answer of performance, there are several other factors to take into consideration:

1) No-load verses load. A load is essentially where you buy/sell the fund and get charged a percentage fee for doing so. I have never bought a mutual fund with a load, as it likely puts a serious dent in the performance/gains. Fees can often be around 5%, so you have to make this gain just to break even again, and where average yearly returns are only in the 7-8% range. Moreover, why pay this fee, when you can in all likelihood buy a similar mutual fund that does not have such a fee?

2) The expense ratio. If you have the option of acquiring one of several similar funds, why not get the one with the lowest expense ratio, as reducing your losses increases your gains. The higher the expense ratio goes over 1%, the less I am inclined to buy the fund.

3) The fund manager. After looking for a well performing fund, without a load and that has a low expense ratio, I also like to take a look at the fund manager. Who is this so-called expert that is running the fund? No all fund managers are equal, some managers have continual years of high performance, but many do not. Although while ‘past performance is no guarantee of future results’, the saying that ‘the trend is your friend’ is also highly applicable to investing, and so I would prefer to go with the consistent, long-term performer.

4) How big is the fund? When a fund gets too big, a value as often quoted at $10 Billion of assets or more, it can become hard for the fund to readily and rapidly buy and sell these assets in the large volumes required, without seriously affecting their price. Thus, stay away from these giants as their performance, which may have been great in the past and that is why they now have so much in assets, could likely suffer due to the inability to more readily respond to the market.