Personal finance author Gail MarksJarvis says investing isn’t complicated — if you understand some important definitions and basic principles. The key to investing is to diversify among funds that invest in different types of stocks and bonds, she says, and not to pick several funds that invest in similar stocks, for example. To learn how to diversify properly, you first have to understand how different mutual funds work.
MarksJarvis offers a simple guide to making sense of mutual funds by explaining how to evaluate their performance and the true cost of a fund as it compares to others. No math skills necessary.
What are some of the vocabulary terms that people
need to know?
I’ve been writing about this for about 10 years and people have no idea what the words mean or what the importance of the words are. So they’ll typically call me and say, “I have a mutual fund and it’s losing money” or “I have a mutual fund and my friends are doing much better. Should I sell my fund?” Well, the fact that it’s losing money is absolutely irrelevant if it’s a certain type of fund in a certain type of stock market.
For example, in the year 2000, almost every mutual fund that invested in stocks was losing money. The fact that your mutual fund was losing money didn’t mean anything because if you were invested in the stock market, you were going to be losing money. What would’ve been important is if you were losing more money than other funds like yours.
If you’re investing in large stocks, you would compare your fund to the index that includes large stocks, and that’s the Standard & Poor’s 500 index. When Wall Street refers to the stock market, they are referring to that index. It’s a rough measure of the stock market, even though it only includes 500 large stocks. But if you have a fund and you are paying a fund manager to select stocks for you and your fund manager is choosing only large stocks and the stock market has been climbing about 8 percent a year and your fund is climbing about 5 percent a year, then you might have a problem if that continues for two or three years.
The funds in a
So those are the three categories that you need to know.
The key decision is how much to put in stock funds and how much to put in bond funds, and that’s based on two different things. That’s based on how many years you have left to save, either for retirement or a house or to go to college. And it’s based on how nervous you get when the stock market goes down. Historically, if you’ve left your money invested for many, many years, you have averaged about a 10.4 percent return (in stocks) versus in bonds, where you’ve averaged about a 5 percent return. That (knowledge) makes you feel secure even when the stock market goes down.
I show people that if they have no idea what to do with their money and they’re saving for retirement and they have 10 years or more to go until retirement or even if they’re on the verge of retirement and they won’t get nervous if the stock market goes down, they could just divide their money up, putting 60 percent in a total stock market index fund and 40 percent into a total bond market index fund. If they did that alone they’d be ahead of most Americans.
You want some of each of those because each of those stocks will act differently when the stock market goes either up or down. When you have some of each, that’s what’s called being diversified.
You should also note international (stocks). You would invest some of your money in the United States and some in other countries, because the U.S. stock market and the stock markets in other countries act a little differently from one another. So when the United States stock market is climbing, maybe it’s not climbing as much as the international markets. But maybe when it falls, the other ones would be the buffers.
International stocks can be more volatile, meaning they could maybe climb more, but also fall more, and so people get nervous. Because of that, most managers don’t say go 50-50, they say (invest) maybe 25 (percent) or 30 percent of all your stock money into an international fund that would invest very broadly in many international stocks.
The average international fund is up about 29 percent in the period from the end of June last year to the end of June 2007. It’s up about 29 percent versus the average U.S. stock fund, which is up about 19 percent.
What happens way too often is that people see the international fund and they say, “Well, that’s the winner. It’s up 29 percent. How can I lose?” What they don’t realize is that the market is always operating in cycles, just like the seasons change from summer to fall to winter.
The same thing happens with parts of the investing world. The fact that international funds have been the winner the last year doesn’t mean they’re going to stay that way. They take turns, not necessarily predictable turns. International funds won’t always be up 29 percent (per) year. The trouble is, you don’t know when winter is going to come when it relates to the market.
Your protection, since you don’t know when it’s going to come, is to divide your money into those different types of mutual funds. You have some money in bonds, and the classic would be a 60-40 split — 60 percent in stocks and 40 percent in bonds. Then you’d divide the 60 percent up with 25 percent of that into international funds and then taking the U.S. stock money and dividing that up 75 percent into large-stock funds and 25 percent divided into small-stock and midcap funds. That would be it; that’s what you could do.
Now, if you’re younger, usually a 60-40 (split) is too conservative. That’s a good mix for people in their 50s that are starting to approach retirement. Or someone who gets really nervous if the stock market goes down; that’s a good mix for them.
But if you’re very young, you need to make your money grow. (Because) the stock market, at least based on history, goes up about 10 percent (per) year, and the bond market goes up about 5 percent (per) year, you need to get that better growth from stocks. If you’re in your 20s, some advisers would suggest that you put everything into stock funds.
The way you cut your risks is you don’t just choose one stock. Chances are if you choose one stock that you won’t win with it. You have many types of stocks and that way, your chances of winning are much better and you always have winners and you always have losers, and the winners buffer the losers. That’s why you do diversification. If you pick one stock, you don’t have that opportunity.
I hear this a lot from people in their 20s. They turn on their TV and they hear Jim Cramer on “Mad Money” on CNBC saying, “This is a great stock. Buy it.” And they think because he said so, they should. But their chance of winning, even though Jim Cramer may be very right about what that stock looks like today, their chance of winning down the line may be very different.
Things happen with stocks that people can’t predict. For example, people look at Kmart, and years ago, people would have said, “Those Kmart stores are everywhere. You can’t lose on Kmart stock.” But Kmart ended up having trouble after a certain period of time and the company went bankrupt.
When a company goes bankrupt, as a stockholder, you usually lose all the value of your stock. Mutual funds usually have about a hundred or more stocks in them. If one stock goes bankrupt, there are many other winners in the fund that will help you get through that.
So, if you compare your fund to the correct index
and you see yours is doing worse, does that mean you have a bad
fund and that you should sell it?
Say you just notice the problem in your
Usually, if your fund is trailing it’s because of two things: First of all it’s very difficult to pick stocks, it’s very difficult to be a winner, and most mutual funds do not win compared to the simple stock market. If you could just throw your money in a stock index fund, you would beat about 70 percent of all the brilliant mutual funds out there.
This is pretty simple stuff. There are all these people with MBAs (Master of Business Administration) who are trying to outsmart the stock market and they’re not able to do it and you have a very simple vehicle in front of you, which would be a simple stock market index fund, and you could probably do it with that. Not every year, not every quarter, but over the many years of saving for retirement. One year, one quarter, probably means very little.
But if it’s two years and especially if it’s five years, at that point I would probably look at one number called the expense ratio. That sounds like a math number, which makes people nervous because it has the word “ratio” in it. But you don’t have to do any math. You can just look at the number. The expense ratio is a number you can find in three ways: You can look it up in the materials that you received with your mutual fund, under fees and expenses. Or you can just ask your mutual fund company, “What is the expense ratio for my fund?” Or you can ask your financial adviser, if you have one. The average for a mutual fund would be about 1.4 percent. But even better, the average for larger mutual funds would be a little less than 1 percent.
Even better would be if you got one of these simple index funds that I’m talking about and paid less than a quarter of 1 percent, which of course, would look like 0.25 percent. Find one even lower than that, if possible.
The reason you would do that is, it’s very, very difficult for a stock picker to outsmart the stock market and to pick all the right funds. I’ve had fund managers tell me that they’re usually disappointed with about 40 percent of the stocks they’ve picked. And they know what they’re doing. So it’s hard to beat the stock market.
There’s one thing you can control, and that’s what you pay to be a part of the stock market, and that’s where the expenses come in. When you buy a mutual fund, you always pay something for the right to have money in it. It may be a quarter of 1 percent, it may be 1 percent. If you are very unlucky and foolish, it’s close to 2 percent. It’s almost impossible for a fund manager to be such a great stock picker that he can make up for the money they’re taking out of your fund to cover their expenses.
People have to watch out for loads, too. Loads are the sales charge that you pay a broker to help you pick a fund. If, for example, you were paying your broker 5.75 percent for a load fund, you would say to yourself, “Well, that’s the cost to play, I might as well pay it; 5.75 percent doesn’t sound like a big number.” But if you were putting $10,000 into the fund, that would mean you were giving your broker $575 to pick that fund for you and that would mean you were putting $9,425 to work.
What about no-load funds?
Those would be like those index funds I’ve talked about. But even with index funds, if you buy them through a broker, you have to be careful because they might still charge you a load, even though the whole idea behind the index fund is to have a simple form of investment where you don’t need advice, you can do it yourself and you shouldn’t have to pay extra fees. The beauty of an index fund is simply that it’s a low-cost fund. It mimics the whole stock market, so it’s cheap because you’re not paying anyone to try to outsmart the stock market. You’re just taking what the market does for you, and that’s usually better than if you pay a fund manager to try to be better than the stock market.
Do you recommend low-cost index funds if they are an
option in a
Yes. Let’s say a person put $10,000 into a low-cost fund that charges, let’s say, 0.31 percent as an expense ratio, or one that just charges the average, the 1.4 percent. After 20 years, the low-cost fund would give you about $63,600 if you had a 10 percent average annual return. The more expensive fund that just charges 1.4 percent would give you about $52,000. You’d shortchange yourself about $12,000. That’s why people tend to do better with index funds than with other funds, simply because that’s a high hurdle for a manager to have to jump to make up for the extra fees that you’re paying.
Incidentally, those fees that you’re paying may be something people might not understand either. You pay the mutual fund company for everything from paying the fund manager’s salary to advertising the fund so that they can get other customers. You pay for that.
Most people have never heard of the word “expense ratio,” and it’s such a simple thing to just look at one number and see, is it 1.4 percent, which is average but not good, or is it 1 percent, which is better, or is it 0.25 percent, which is a lot better? People don’t have to do math to do that, they just have to look at it and say, “Is the number higher or lower? I want the lower number.”
If it’s in the
Why is it a bad idea to pick stocks, watch their
performance and then sell them if they drop below a certain price,
as opposed to choosing a mutual fund?
The trouble is people make those promises to themselves and they don’t keep them. There’s actually behavioral research on this done by people who have studied both psychology and finance. Most people don’t like the idea of a loss, and so once their stock falls, even though they promised themselves that they would watch it, they say to themselves, “Well, I think it’ll come back,” and they wait. What they don’t realize is that stocks have no memory. Just because you bought the stock at $50 a share, doesn’t mean that it’s ever going to return to that. So a lot of times what will happen is, people will buy it and hold it after things have changed a lot since the day they bought it, and it’ll just keep going down.
There was a a group of stocks in the 1970s called the Nifty 50 and at the time Wall Street was saying, “You can buy these stocks and hold them forever and never think twice about them, because they are such great companies they will be there forever.” Well, you want to hear some of the names of those? Polaroid, which dealt with cameras, fell 91 percent and the stock never ever came back to the price people had paid for it. Another one was Avon, the makeup company. We don’t think of that as a hot stock today, but in the ’70s that was a hot stock.
The point is, there’s a hot stock today, too, that won’t be a hot stock later. You just don’t know it. Because you don’t know it, it’s dangerous to buy just one or two stocks.
Instead you buy numerous stocks through a mutual fund. Mutual fund managers make mistakes. Often, they’ve said to me (that) about 40 percent of their stock picks they consider mistakes. And they’re brilliant. They are running all kinds of tests on these companies and if they can’t do it 100 percent of the time, then why do you, an individual, who has no idea how to look at the numbers, think you can do a better job? Just because you watched a TV show and someone said it looks like a good stock?
What are some do’s and don’ts for people with
short-term investing goals, such as saving for a down payment on a
house? What types of investments make sense and which
If you’re within five years of needing your money, history shows that the stock market can go down significantly during that time period and you could end up with less money than you originally put in. So the rule of thumb is that that money shouldn’t go into the stock market. You need something safer. Safer could be CDs that you would get at a bank; it could be a money market fund. I draw a distinction here — the words “money market” are on two different types of accounts that are not the same. There’s a money market fund and a money market account. Typically the interest rate on a money market account is not as good as a money market fund and yet they’re both fairly safe — not 100 percent safe, but very, very safe.
You can get a money market fund through a mutual fund company. You can shop for CD rates on Bankrate.com. Sometimes there are high-interest savings accounts that are as good as money market funds, and you can also find those at Bankrate.com. You can perhaps put money real simply into just a high-yielding savings account. You should be able to get right now close to 5 percent interest on a money market account, or one of these high-yielding savings accounts. You don’t lock your money up — it’s there if you need it for the down payment and you’re not taking a risk with it.