How to Invest in Mutual Funds

Investing in Mutual Funds

How to invest in mutual funds? is a timely topic because the stock market is lower now (October 17, 2008, Dow 8852) than it's been for a long time. However, the best way to invest in mutual funds is to invest every month before spending, either through a 401k plan where you work or in an IRA. Both will save on income tax when you invest, and both will allow your savings to grow untaxed until retirement. That much is simple.

There are thousands of mutual funds to choose from and making the correct choice can be complicated.

The following considerations are important:

(1) Does the fund require a sales charge (load) or broker's commission ? Most objective investment advisers advise choosing no load funds because loads or commissions which can be as high as 5 percent mean that your initial investment and subsequent purchases are reduced by the amount of the sales charge. Moreover, the evidence is that load funds do not perform any better than funds that come with no sales charge.

2. What is the expense ratio of the fund? Expense ratios are the cost you pay out of your investment to the fund company for managing your investment in the fund. Expense ratios range from as low as .19% for large index funds to as high as 5% for some managed funds. Again, most investment advisers say that, all other things equal, a fund with a low expense ratio is a better investment than one with a high expense ratio because the expense ratio comes off the top from the money you invest. The record shows that about 2/3 of all managed funds do not beat the benchmark Index 500 (a composite index of the performance of the 500 largest industrial companies). High expense ratios are one reason for their relatively poor performance compared to plain vanilla index funds.

3. A third decision when investing in mutual funds is whether to invest in a managed fund or an index fund. Many if not most investment advisers recommend no load index funds for the average investor because they have low expense ratios and offer broad diversification. Moreover, because index funds trade (buy and sell stocks) very little they save on capital gains taxes for their investors in taxable, non-401k or non-IRA accounts. Savings from low expense ratios and taxes are be quite significant over a period of years.

4. A fourth decision important to mutual fund investing is whether to invest in a single fund or several funds. The best advisers recommend dividing your investments among funds that invest in the following sectors:

1. Domestic large company stocks

2. Domestic small company stocks

3. International stocks.

4. U.S. Treasury bonds.

The younger you are and the longer the period before you will need the money, the smaller the portion of your portfolio you should have in bonds. The closer you are to retirement the higher the recommended percentage for government bond funds. Also, whether or not you have or expect to have a pension from your employer may affect your decision on whether or how much of your portfolio should be invested in government bonds. If you have a secure pension, the need for bonds in your portfolio may be less than if you are relying only on your mutual funds and Social Security for retirement. John Bogle recommends a very simple rule for deciding what percentage of your investment portfolio should be in government bonds: as you approach retirement the percentage devoted to bonds should equal your age. If you are 60, 60 percent of your retirement funds should be in bonds, if you are 70, 70 percent and so forth.

SECTOR FUNDS

If you read the reports of fund performance for the previous year you will see that many of the highest performing funds and the lowest performing funds are those that invest in narrow sectors or markets, e.g, gold, metals, energy, emerging markets, real estate and the like. These funds are risker than those which invest in a broader portfolio.Their results fluctuate much more widely than a broad index or managed fund. Often the funds that placed at the top for one or two years end up at the bottom the following year.

INDIVIDUAL STOCKS

Investing in the stock of an individual company exposes you to several risks

1. Company risk: The company may fail or do poorly because of competition or because of changes in technology.

2. Industry risk: The company's industry may decline, e.g. buggy whips or carbon paper.

3. Economy-wide risk: The company's stock may decline as a result of a recession in the U.S. economy.

A portfolio of broad index funds protects the investor against all risks but that resulting from a recession in the economy. Narrow sector funds offer protection against the risk of investing in a single company, but not against industry-level risks or the risk of a general market decline as a result of unfavorable economic conditions in the entire economy.

Finally, virtually all investment advisers agree that investing in the stock of the company where you work is a very bad idea. Investing in the stock of your employer combines the risk that you may lose your job with the risk that you may lose your investment. Moreover, the value of your house may be reduced if you work for a large employer that declines or fails and affects your community adversely. We've all heard of Microsoft and Google millionaire employees. However, these are rare exceptions that are outnumbered by employees of companies like Enron, the automobile companies, investment banks and others who have seen their life savings go down the drain.

RESOURCES FOR INFORMATION ON MUTUAL FUNDS

One good place to start before investing in a mutual fund or funds it your local public library which is likely to have all kinds of resources which you may find helpful for evaluating mutual funds. Morningstar is a popular source of information on mutual fund performance although it's data is not without problems. The websites of big mutual fund companies such as Vanguard offer a wealth of information about their funds. The Vanguard Group's homepage is linked below.

If you are serious about saving and investing here are the two best books I've read on the subject:

"Winning the Loser's Game" by Charles D. Ellis and

"Unconventional Success: A Fundamental Approach to Personal Investing" by David Swensen

Charlie Ellis advises mutual fund and pension fund managers, and his personal investments are primarily in no-load index mutual bunds.

David Swensen is a finance professor at Yale University and also manages the highly successful Yale University endowment fund. He recommends no-load index funds for most investors.

Also, John Bogle, inventor of the index mutual fund and founder of Vanguard Mutual Funds, has written several excellent books on investing. He is also a strong advocate of tax-efficient, low-cost, no-load index mutual funds for the average investor.



Warren Buffett, the Sage of Omaha

Warren Buffett on Investing 10-17-08 NYTimes

Op-Ed Contributor Buy American.

By WARREN E. BUFFETT Published: October 16, 2008 Omaha

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month - or a year - from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor's best friend. It lets you buy a slice of America's future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: "I skate to where the puck is going to be, not to where it has been."

I don't like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I'll follow the lead of a restaurant that opened in an empty bank building and then advertised: "Put your mouth where your money was." Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

 

 

"Enough" by John C. Bogle

In his book, "Enough," released in December 2009 John Bogle comments on the current world economic crisis, on what's wrong with Wall Street and the mutual fund industry (both are not designed to function in the interest of investors). This is an outstanding little book of 250 pages written in plain English that anyone can understand.

Bogle on Recession/Economic Crisis

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Comments 9 comments

vitaeb profile image

vitaeb 7 years ago from Shenandoah Valley, Virginia

Thanks for the interesting information you've provided. This is a world I am totally ignorant of. Unfortunately for me, these insights do little to further my monetary future, as I am beyond the age of making inverstments, and don't have the excess funds in any case. That said, i recommend that young people read your report.


guidebaba profile image

guidebaba 7 years ago from India

Thank you for answering my request an this excellent explanation. I will wait for a month or so to see where the market is going and then take some decision.


Ralph Deeds profile image

Ralph Deeds 7 years ago Author

Figuring out when the market has reached a bottom and started back up is very hard to do. Many advisers advocate investing in stages rather than putting your money in all at once and all recommend investing regularly by payroll deductions, especially if your employer provides a match.


Storytellersrus profile image

Storytellersrus 7 years ago from Stepping past clutter

Ralph, I am going to bookmark this Hub for the day when I have money to invest, lol. Thanks!


Ralph Deeds profile image

Ralph Deeds 7 years ago Author

Bogle and Buffett are predicting a deeper and longer than normal recession, but not a depression.


Research Analyst profile image

Research Analyst 7 years ago

Its interesting how little we know about finances, budgeting and investing, but we know a lot about spending, consuming and getting in debt. LOL

Thanks for the information.


Ralph Deeds profile image

Ralph Deeds 7 years ago Author

RA, thanks for your comment!


worldscope profile image

worldscope 7 years ago

StoryTellersRus, you do not have to wait to earn a lot of money to start investing. With less than $100 a month you can invest in exchange traded funds or retail mutual funds. The idea is to start as soon as possible with whatever little you have. Then you will have the motivation to learn more and increase the profitability of your investments when your finances improve.

Vitaeb, you are not beyond the age of investing. No matter how old you are, you can still choose to put the money you have in a fixed interest earning account instead of a no-interest checking account with monthly fees. That too is an investment decision.

There is no bad time to start investing. You can always find good deals even in a recession. The challenge for the common person is to learn how to manage fear, greed, inactivity and ignorance. When good opportunities exist, the common person is too fearful and inactive. When the good opportunities have just passed, the common person is ignorant of the fact and greed accelerates into overdrive.


Ralph Deeds profile image

Ralph Deeds 7 years ago Author

True. Let us know when the market bottoms. :-)Thanks for the comment.

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