Basics of mutual funds
Why invest in mutual funds? Well, they give you the
power to buy many individual stocks, the best advice in the business
and discounts from your broker -- all of which gives you the same
clout on Wall Street as the big guys.
Do-it-yourself small investors buying and selling
individual stocks get none of these things, warns Matt Thompson,
an investment adviser for First Dallas Securities in Dallas, Texas.
"My favorite point in favor of mutual funds is that
you automatically get professional management," Thompson says. "Also,
with mutual funds, you achieve automatic diversification. You spread
your money across 40 or 50 stocks and have less risk.
"When using mutual funds, investors take a more long-term
outlook. The diversification in a fund's portfolio and allocation
between stocks and bonds tends to take out the big swings in price."
How to invest in mutual funds
Investors buy into mutual funds to pool their money
to buy a diverse portfolio of stocks and bonds.
If you've decided to join them, congratulations, you've
already made a smart investment move. Now, you have to ask yourself
some tough questions:
- Am I a short-term or long-term investor?
- What's my risk tolerance?
- How many fees am I willing to pay?
- Do I want to research and pick the funds
myself or go through a financial adviser?
Short-term vs. long-term investor
If you need to use your money soon for college or
a down payment on a house, consider money market mutual funds and
bond mutual funds.
"If you are investing for a year or even two years,
you should not be investing in stocks," says Carla Freid, managing
editor of Quicken.com. "There's no guarantee that the money is going
to be there."
On the other hand, money market funds invest in ultra-safe,
short-term securities such as treasury bills. Money markets pay
higher annual interest than you'll get in an ordinary savings account,
and some funds are even tax-free.
Bond funds have varying yields. The longer the maturity
on the bond the more risky it will be. A long-term bond fund can
yield 7 percent annually. A short-term bond fund returns 4 to 5
percent. Some bond funds are tax-free, too.
But what if you're investing for the long term --
10 years or more? Stock funds are for long-term investors; those
who can weather the stormy seas of a volatile market to reach the
distant shores of 10 percent and higher annual return.
For example, if you've got 15 years until retirement,
max out your Roth IRA contribution every year, put it in a stock
mutual fund, and let it ride. In the long run, your ship will come
Is your middle name "Danger," or "Safety Sam?" No
matter. With 10,000 funds to choose from, there's something for
And, if you want to play it safe, stick with bond
funds. Your money will earn more interest than it would in a savings
account, and you'll sleep well at night. If you're completely fearless,
you can put all your money in an Internet (gulp!) mutual fund, then
watch it go up and down like a Slinky on steroids. Most folks choose
a combination of funds to match their own needs and goals.
No matter what your risk tolerance, here's a dirty
little secret: YOU can be the biggest risk to your investment success.
That's right, Buckaroo. Mutual funds work best if they're held long-term.
But if you cash in to go chasing after the hot new fund of the moment,
you'll miss out on the long-term gains of the buy-and-hold investor.
Sometimes, the best thing to do is to do nothing.
Just listen to the quiet rustle of your money growing. "Don't beat
up a fund if it has a down quarter or even a down year," says Freid,
who covered mutual funds as a reporter for Money magazine.
Thompson adds: "If you've got a good, well-balanced
fund, just check on it once a quarter."
Some experts say there's no reason to ever buy a mutual
fund with a sales fee, which is known as a load. But others
say a load is not necessarily a bad thing. "If you've hired a financial
planner or financial adviser, the load can be a form of compensation
to that person," Freid explains. "But if you're paying the adviser
[for his or her time], why are you paying a load?
"If you can find a better alternative with no load,
then go for that."
If you're a long-term investor, it's sometimes better
to pay a front-end load with low yearly operating expenses, known
as the expense ratio, says Kay Shirley of Atlanta, a certified
financial planner and author of The
Baby boomer financial wake-up call.
"You can buy funds that are front-load, back-load
and no-load, but don't be fooled into thinking that there's such
a thing as a true no-load," Shirley declares. "A mutual fund company
has to pay managers, overhead, research, marketing. On those no-load
funds, it comes out of your accounts one way or another."
She says that many front-end load funds have lower
expense ratios than no-load funds. The exception is a no-load index
fund, which is basically run by a computer, and therefore has very
Do-it-yourself or a financial adviser
Should you use a financial professional to help you
pick funds when the funds are professionally managed? It depends.
Doing it yourself means devoting serious time to learning.
The self-education approach minimizes your fees, and
if you choose a mutual fund with low operating expenses, such as
an index fund, you're already ahead of the game.
On the other hand, handling money is a big responsibility
and time-consuming. If you need professional financial advice, read
Bankrate.com's story on choosing
an adviser, as well as our story on hiring
someone to handle your mutual funds.
The best way to invest in mutual funds
When you're ready to invest in a mutual fund, consider
an investment plan known as "dollar-cost
averaging." If you have a 401(k) plan that automatically withdraws
from your paycheck, you're dollar-cost averaging right now. To do
it on your own, put a set amount into a mutual fund every month.
The neat thing about this system is you buy more shares
of stock (or funds) when the price is low, and buy fewer shares
when prices are high and the market is over-valued.
You can dollar-cost average by having money automatically
withdrawn from a bank account, and avoid the dreaded "M"-word: Minimum
-- as in deposit. If you don't have the $2,500 or more that some
mutual funds require to open an account, Freid says, "promise to
sign up and have $50 to $100 automatically put into the mutual fund
every month. In most cases, the mutual fund company will waive the
Big families of funds
Putting your money in a big family of funds, such
as Fidelity or Vanguard or T. Rowe Price, gives you more choices.
Each of these big families has many different kinds of funds to
suit many investing styles. You'll have diversity on top of the
diversity built into each mutual fund, and it's easy to move money
from one fund to another without paying fees.
But remember, any time you cash out of a fund, even
if it's to move into another fund in the same family, you're going
to have to pay taxes on your profits -- unless your money is in
an IRA or another tax-exempt vehicle.
Also, putting money in different funds in the same
family may not get you the diversity you seek. Often, funds within
the same family invest in many of the same stocks. Just be sure
you know what you're buying.
There are three ways to minimize taxes on mutual funds.
- Invest through a tax-sheltered retirement
- Invest in tax-free mutual funds
- Invest in funds with low turnover
Tax-sheltered retirement accounts, such as 401(k)
plans and IRAs, are great vehicles for mutual fund investments.
Most people can put as much as $2,000 a year in a Roth or regular
IRA, and as much as 15 percent of their income in a 401(k). For
more information, read this story on IRAs
Tax-free mutual funds are usually municipal bond funds.
The return on these is lower than stock funds, and unless your income
is really high and you have serious concerns about taxes, they're
probably not the best idea.
Funds with low turnover -- or shares of stock bought
and sold -- are the best option for people who can't shelter their
mutual funds from the taxman. An example is an index fund. Though
individual investors buy and sell millions of shares of stock every
day, the composition of an index doesn't change that much. A fund
based on the index will have relatively few trades ... and low turnover.
-- Posted: May 3, 2000