Who Should Invest in Mutual Finds?

Anyone who has money they won’t need to touch for several years needs to invest in equities (stocks) to prevent the loss of their savings due to inflation.  Likewise, anyone who wishes to become wealthy should consider stock investing as a way to magnify their earning ability.  By investing, one can gain income in exchange for allowing others to use their capital and by doing so grow net worth at a rate that is much greater than most people can earn through simply working.

There are two ways that investors can participate in the stock market – by buying stocks directly and through mutual funds.  Deciding which way is appropriate for you depends on several factors including your time available to research investments, your tolerance for volatility, your investment objectives, and your interest and ability to pick stocks.

Buying individual stocks means selecting from the thousands of choices available the small basket of stocks one would like to own.  It also means deciding when to buy, and probably more importantly, when to sell.  Buying individual stocks means being able to control one’s emotions and determining the best choices for a position while prices are moving up 100% or down 50% in a single year or even a period of a few weeks.  It also requires more study to learn the mechanics of putting in trades, the nuances of things like ex-dividend dates, and more bookkeeping when it comes to income taxes.

By buying stocks directly, one can outperform the market.  Instead of buying all ten of the stocks in a market sector, you can pick just the top one.  If you have a talent for sorting out the good businesses from the bad, you can do much better than the market return.  You also have the advantage that you don’t need all of your picks to be good, just one or two to be great.

There are certainly advantages to mutual funds as well, however.  In buying a mutual fund, one is pooling her money with that of thousands of other investors.  That pool of money is then used to buy 100, 200, 500, or even 1000 different stocks or more.  Buying mutual funds gives automatic diversification, which will reduce the chance of losses and generally reduce the amount of volatility so that the value of your portfolio will be more stable.  While there are years when the market will move up or down 40%, most years will result in swings of 20% or less.  Also, while buying mutual funds guarantees only matching the market, minus fees and expenses, mutual funds are easily bought, and once purchases require almost no maintenance at all.

Given the choice between individual stocks or mutual funds, one should buy mutual funds if most of the following are true:

1.  You tend to be worried by large fluctuations in your portfolio value.  If a drop of 20% would cause you to sell and hide under a rock, individual stocks aren’t for you.  If you would take advantage of the lower prices to buy more shares, you have the right psychology.

2.  You don’t have the desire to learn about the markets or do the research needed to find good stocks.  Many people have other things that they would rather be doing than reading the Wall Street Journal and Money Magazine.  If this is true of you, maybe mutual funds would be a better choice.

3.  You don’t have time to do the research to find good stocks.  Because mutual funds are the market, finding good mutual funds requires a lot less time than finding good stocks.  Granted, once you have found a basket of good stocks the time required to maintain the portfolio drops dramatically, so long as you are investing for the long-term, but it does take an initial investment of time.

4.  You have a lot of money.  The more money you have, the more important it is to have the proper diversification to reduce the chances of a large loss.  A person who has $2000 to invest can well afford the loss of the $2000 in a single stock, provided he is raising money from his salary and investing regularly.  A person with $1 million cannot afford a loss of the whole $1 million from large positions in a few stocks.  A good portion of that money, say 50%, should be in mutual funds.  Another portion, say 30%, should be in several large, solid, dividend paying stocks and bonds. The remainder can be in larger position in individual growth stocks, if desired.  As one’s wealth grows, a portion should be diverted into mutual funds.  That portion should grow with the value of the portfolio.

5.  You can’t leave things alone.  People who are constantly trading will never make money in individual stocks.  If you find yourself constantly watching CNBC, unable to stick to a position for long periods of time, you would be better off buying mutual funds and using some of the proceeds each year to fund a trip to Vegas.  At least that way you’ll get a change of scenery and drinks will be included.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Factors to Use when Picking a Mutual Fund

Selecting mutual funds is far less involved than selecting individual stocks. Because mutual funds invest in a wide variety of stocks (or bonds, or other
asset classes), virtually any mutual fund will provide about the
return of the market minus fees and trading expenses.  The main
things to consider when selecting a mutual fund are therefore
expenses and investment objectives.

Investment fees, including fees when shares are purchased or redeemed – called the “load”, and yearly operating fees and expenses, are important
considerations.  In general, because most mutual funds will track the
market over long periods of time minus fees and expenses, minimizing
fees and expenses will maximize returns.

In selecting mutual funds, many people would buy the one that performed the best over the last year or two.
After all, that manager might have some secrets that allow him to
generate those 20% returns.  Why would someone want to settle for a
paltry 5% return when one could get 20%?

One must be careful to read that little
disclaimer that is at the bottom of all mutual fund advertisements:
“Past performance may not be indicative of future results.”  Just
because a stock fund or a sector of the market does well a certain
year does not mean that it will continue to outperform its peers.  In
fact, because the fund has done well it is more likely that the
stocks in the fund will be overpriced and that it will lag its peers
the next year.  Likewise, just because a stock fund does poorly in
any given year does not mean that it will do poorly the next year.
It is the result of this chasing performance that most people buy
funds right before they are ready to fall off and sell them just
before they are ready to shoot up.

Rather than using past performance in selecting mutual funds, one should consider the following:

1) Check the fees compared to other
similar funds.  If fees are high (greater than 1%), it would be wise
to change to a less expensive fund in the same sector.  Index funds
tend to have very low fees.

2) Evaluate the segment of the market
in which the fund invests and decide if it si a sector in which you
wish to be invested.  If you are in an emerging markets fund the
performance will likely be all over the board with some spectacular
years and some dismal years.  If you buy a bond fund it will not
perform as well as a stock fund over a long period of time, but int
he bad years it will probably hold up better.  For example, in 2008
stocks fell more than 20% while bond funds generally had a positive
return.  It is therefore a good idea to own funds in different
segments of the market with the balance depending on how long you
have to invest the money.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Basics of Mutual Fund Investing – What is a Mutual Fund

Many investors use mutual funds to
invest rather than picking stocks individually.  Mutual funds are
agreements by which investors buy shares of the mutual funds rather
than buying shares directly and then a professional money manager
purchases shares of stock with the proceeds of the fund.  Investors
pay a fee to the manager and pay for investing expenses.  The net
profits and dividends are then distributed to the shareholders of the
mutual funds depending on the number of shares they own.

 

The advantage of mutual funds is that
they allow investors to achieve diversification – spreading
investments out over a large number of stocks rather than in just a
few companies – without requiring the large sums of money that
would be necessary to buy a large number of stocks directly.
Investors with modest amounts to invest therefore often invest
through mutual funds, although even some large investors use mutual
funds just to reduce the hassle of picking stocks.  There is also a
school of thought that believes that buying a large basket of stocks
will be better than selecting a few stocks most of the time since the
risk of selecting the wrong stocks does not justify the opportunity
for additional gain, so it just makes sense to buy mutual funds
rather than trying to pick stocks.

 

The main disadvantage to investing in
mutual funds is that the fund manager, because he has so much money
under management, must buy not only his top picks but several other
stocks in each sector.  This means that the return of a mutual fund
over time will almost always mirror the return of the market into
which it is invested minus the fees to the managers and expenses.  A
second disadvantage is that an investor has little control over the
investments made by the fund manager other than the selection of the
type of fund.  Even still, care must be taken to verify that the
investment objectives of the fund and  the restrictions on how the
fund may invest are consistent with the investment objectives.  The
third disadvantage of buying mutual funds is that the investor has no
control over when capital gains are realized.  This means that even
if one is fully invested in a fund and does not sell shares, the
investor will receive capital gains distributions because the manager
has sold shares at a gain and taxes must be paid on these gains.
This reduces the ability to delay capital gains taxes and time the
realization of gains.

 

Mutual funds come in different
“flavors,” with the most significant difference being between
open-end and closed-end mutual funds.  In an open-end mutual fund
there is no fixed number of shares and investors buy and sell shares
directly from the mutual fund company with the price normally set
based upon the value of the holdings owned by the fund, called the
“net asset value,” at the end of the trading day.  If a person
decided to buy 100 shares, for example, the fund would accept his
investment and create 100 more shares of the mutual fund.  With a
closed-end mutual fund the number of shares is fixed (although some
funds issue more shares at times) and the shares are then traded on a
stock exchange between investors just like a stock.  Exchange Traded
Funds, or ETF’s are a relatively new form of closed-end mutual fund
designed to mimic specific sectors of the market.

 

Open-end mutual funds can only be
purchased once a day and the price is determined by the value of the
underlying stocks owned by the mutual fund.  The disadvantage of this
arrangement is that if a group of investors decide to sell shares the
mutual fund manager may be forced to sell investments to generate the
money needed to pay the investors.  This may force the manager to
sell shares when prices are depressed (because people tend to leave
funds when the price of stocks is declining).

 

In addition, some mutual funds have had
issues in the past in that investors were allowed to buy shares at
the closing price of the previous day after the opening of the next
day.  These investors were then able to sell the shares quickly and
realize a profit at the expense of the long-term holders of the fund.
This  practice is normally illegal, but tit happens every so often
nonetheless.

 

Closed-end mutual funds are not
affected by sales and there is no way to game the system because the
shares are traded among investors.  The price of the mutual fund
shares is set based on what investors are willing to pay for them at
any given time.  This means that the price may be greater or less
than the value of the holdings per share.  If the price is greater
the mutual fund is said to be trading at a premium.  If less
it is said to be trading at a discount.

 

At first the concept of selling the
shares at a discount or buying them at a premium makes little sense.
Investors may sell shares at a discount, however, if the mutual funds
has performed so badly that they decide that they are willing to give
up a bit of the underlying value just to put their money somewhere
else with a better return.  Likewise, investors may pay a premium for
a mutual fund if they believe the returns will be better than those
of their competitors over time or the mutual fund pays a dividend
that is large compared to other returns.  A special risk of closed
end funds, however, is that they sometimes convert into open-ended
funds.  When this occurs, the fund quickly changes to its net asset
value.  If the shares were bought at a premium to asset value, a
quick loss will occur.

 Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

When Should Someone Sell a Mutual Fund?

Ask SmallInvy

Dear SmallIvy,

I was wondering when someone should sell a mutual fund.  I have a few that have not done as well as the market over the last year.

Thanks,

Rick

Dear Rick,

Here are the only reasons to sell a mutual fund:

1.  You made  a mistake when purchasing and bought one with high fees.  Because mutual funds follow the market, the only difference in performance over long periods of time is due to fees.  Make sure your funds have low fees.  Index funds and ETFs are great for this reason.

2.  You have a fund that has done really well, causing the allocation of your funds in that sector of the market (for example, large caps, small caps, foreign stocks) to be too large a percentage of your portfolio.  In general you should pick an asset mix based on your objectives and rebalance periodically to return to the desired mix.  Note this has the desirable effect of selling those sectors that have done well (selling high) and buying those sectors that have not done as well (buying low).

3.  You will be needing the money in a few years and it is too risky to leave the money invested and taking the chance that a market fall will occur.  Remember that stocks are for long-term investing (greater than five years).  If you’ll be needing the money, you should settle for the pitiful returns of CDs for the security they provide.

Notice that the fact that “the fund performed poorly relative to its peers” is not on the list.  If a fund is doing poorly, take a look at the fees and the investment objectives.  If you decide that the fees are reasonable and the objective is what you think it is, stay with the fund.  If you sell your fund and buy the hot fund of last year, chances are you’ll be selling a basket of discount stocks and buying a basket of overpriced stocks.  Unfortunately, this is what many people do.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Should You be a Stock Investor or a Mutual Fund Investor?

In general, chosing individual stocks requires more skill and the ability to pick stocks, but the advantages are higher potential returns and control over when and how the securities are traded.  Mutual funds offer instant diversification and generally require little investing skill, but the investor has little control over when trades are made and the resulting cost and tax consequences.  In this article, both strategies are discussed to give the reader information needed to make the choice.

Investing in individual stocks and investing with mutual funds could be likened to driving a car with a manual transmission or an automatic transmission, respectively.  For a person who likes to drive, a manual transmission and the control it provides is very desirable.  On the other hand, for a person who just sees a car as a means of transportation, the need to manage the gears could be seen as a nuisance.  Likewise, someone who is skillful with a manual transmission can achieve better fuel economy, but an individual who does not understand what he is doing might end up burning more fuel with a manual transmission than an automatic.

The main advantage of individual stock investing is control over the investment.  By selecting stocks with a long-term growth horizon, one can buy and hold stocks for long periods of time, thus reducing trading costs and capital gains taxes.  In fact, if one could buy and hold a single stock for one’s whole career, one would not pay any income taxes until the stock was sold at retirement even if the stock was not in a sheltered retirement account.  One is therefore able to take advantage of compounding.

A second advantage of individual stock investing is the ability to select just the stocks one really believes in.  Rather than buying one’s first, second, third, and fourth choice in each business line, one can select just the cream-of-the-crop.  If one feels that Apple Computer is a great investment, one could just buy Apple Computer.  A mutual fund manager, because he has so much money under management, would need to buy Apple Computer, Dell, IBM, and several other companies to fully invest all of the cash he has.  Even if he had the same strong convictions about Apple Computer, there would not be enough shares available for him to buy at any reasonable price.  He would also be very clumsy when entering and exiting the market because of the necessarily large size of his positions.

A third advantage is control of fees and trading costs.  When in a mutual fund one typically needs to pay fees to the fund managers and mutual fund company each year.  One would also need to pay some of the marketing costs for the funds and for the trades that the managers decided to make.  If one holds individual stocks long-term, the only costs will be the yearly fee for the brokerage account, which would typically be about $100 even for a million dollar account.  If that is too much one could even ask for stock certificates to be sent and keep them in a safe deposit box or under one’s mattress.

One disadvantage of individual stock investing is that it requires a level of skill by the investor at picking stocks.   If one is a poor stock picker and one’s picks lag behind the market, one would have been better off in a mutual fund.  This means that individual stock investors must be able to read the balance sheets of  companies and know what factors indicate a good likelihood of success.  Often various publications are required to give the needed information.  Likewise, he must know how to enter a trade and establish a position.    Finally, he must have a sense of the state of the economy and be able to see which industries will prosper.  In many ways the ability to pick stocks is more of an art or a craft than a science. 

A second issue with individual stock investment is that the level of fluctuations in individual stocks is fairly high.  It is not uncommon for an individual stock to rise by 100% or fall by 50% or more in a single year or even over a period of several weeks.  For those who are nervous about investing, these fluctuations could make it difficult to sleep at night.  Worse, anxiety could cause one to make irrational decisions, locking in losses and missing out on big gains.

Like the automatic transmission car, mutual funds are well suited for those who just want to use investing as a utilitarian way to build wealth.  One will never be able to beat the markets — in fact one will lag the markets by a few percentage points due to the fees charged — but one will certainly make a good return with little personal effort.  Because the investment is spread out over many stocks – a trait called diversification – the level of fluctuations will be far more subdued.  Typical fluctuations in value of +/- 20% or less are typical.

The disadvantage is lack of control over the frequency of trading, which could lead to capital gains being booked each year, decreasing the ability to compound gains and driving up costs.  Investing in index funds or Exchange Traded Funds (ETFs), which have a specified investment mix, can substantially reduce the frequency of trading (called churn) and fees overall since a full-time management team is not needed.  If investing in mutual funds, the secret is to find the funds with the lowest fees (this is the biggest indicator of long-term return) and to avoid chasing returns (if you buy the funds that did the best last year you will likely be buying a basket of high-priced stocks). 

Finally, there is no reason that one can’t hold a portion of one’s portfolio in individual stocks and the remainder mutual funds.  In fact, as one accumulates wealth, it makes sense to put a substantial portion in mutual funds since the diversification they provide will help protect the value of the portfolio.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing