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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?
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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 "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 in.

Risk tolerance

Is your middle name "Danger," or "Safety Sam?" No matter. With 10,000 funds to choose from, there's something for everybody.

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 low costs.

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'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 minimum deposit."

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.

Minimizing taxes

There are three ways to minimize taxes on mutual funds.

  • Invest through a tax-sheltered retirement account
  • 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 and 401(k)s.

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


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