For this week’s lesson, let’s start with the basics! Today we’ll cover the investment vehicle called mutual funds. So what are they? Imagine this scenario. 10 of your friends want to start investing, but most of you don’t know how to choose good companies’ stocks and bonds. One of your friends, however, is an investing expert who studied business in college and they’ve worked and invested at the stock exchange for more than 20 years. Because he’s good at choosing investments, you all decided to pool your money together and have him handle it for you (you also give him a small commission). You all earn some profit depending on how well your friend’s investments work and how much money you’ve invested with the group. That is basically how a mutual fund works.
A mutual fund is an investment where lots of people pool their money together to invest in assets like stocks, bonds, money market, or other assets. These funds are operated by professional money managers and their goal is to invest the fund’s resources to earn money for the shareholders. That’s you when you invest in a mutual fund by buying their shares.
Now why should you consider investing in them?
Well one of the biggest reasons is that they can earn FAR more than any savings account or time deposit accounts in any bank. “Investing” your money in savings accounts is similar to putting seeds in the freezer as compared to planting them in a farm. They’re not going to grow, and they’ll just lose value because of inflation. Remember how $1 or P50 used to be a lot of money in the 1970s but can’t buy much now? That’s inflation at work.
By investing money in mutual funds (or other investments like stocks or real estate), your money can grow faster than inflation depending on how well the mutual fund’s managers do.
Another advantage? Unlike investing in individual stocks or bonds where picking the wrong stock can destroy the value of your money, mutual funds are often diversified. That means your money is spread out among multiple investments in order to reduce risk. Think of it like putting your eggs in multiple baskets. If something bad happens to one basket, then at least all the others are still safe.
There are many kinds of mutual funds. Here are a few examples:
- Some invest purely in stocks or equities. These have high volatility (wild price changes, like riding a roller coaster) and risk but have high potential returns.
- Some invest in bonds, which have lower volatility and lower potential returns.
- Some invest in money market instruments.
- Others invest in combinations of the above. They are usually called “balanced funds” which have stocks for growth, but also invest in bonds to lower volatility.
- There are also funds-of-funds which invest in OTHER mutual funds.
One thing to remember: READ THE PROSPECTUS.
The prospectus is a document containing the most important details of the fund. It contains details like the fund’s investment objectives and restrictions, its fees, minimum maintaining balance, minimum partial redemption, the names and backgrounds of the money managers, the fund’s performance information, and many more.
One of the greatest mistakes you can make is not knowing what you’re investing in. Study the prospectus first to learn more about where you’re putting your money into.
Some Advantages of Mutual Funds:
- Mutual funds are diversified.
- Your money is managed by professionals.
- There are many different kinds of funds so you’ll likely find one that suits your needs.
- The fund’s fees eat your investment’s returns.
- Money managers are still prone to human error.
Now you might be thinking of investing in individual stocks or bonds instead of mutual funds. You can certainly do that if you’ve studied those assets carefully and you’re well aware of the risks. If you haven’t, it might be better to invest in mutual funds. Ric Edelman, the author of Ordinary People, Extraordinary Wealth explained why he thinks you’re more likely to earn more investing in mutual funds than in individual stocks:
“If you don’t agree with this statement, buy your own stocks and bonds. If you do agree, choose mutual funds. If you’re not sure, choose mutual funds—because if you try to find out whether you agree or disagree by picking your own investments, you’ll cost yourself a fortune. As my father told me while teaching me to drive: If you know how to cross the intersection safely, do it. If you know you can’t, don’t try. And if you’re not sure, don’t try until you are sure. My dad’s advice has saved my butt more than once.”
Choosing the Right Fund:
First off, find out what your tolerance for risk is. Can you stomach your investment gaining or losing money at a rapid pace in the short term (but generally gains money in the long term)? Are you fine with leaving your cash invested in something for years? Are you relatively young? Consider funds that invest mostly in stocks or equities.
Do you hate risk and prefer something very slow but steady (low risk, but low potential gains)? Will you need to withdraw the cash invested soon? Are you old and you need a “safe” investment? Consider funds that invest mostly in bonds or money market funds.
By the way, remember this warning: “Past performance won’t predict future performance.” Just because a fund did well the past several years that doesn’t mean it will keep doing well during the next. The top fund can become the biggest loser in the blink of an eye. Just remember that the next time some “financial adviser” (a.k.a. salesperson) promotes their fund to you (just read about what my friend experienced here).
For another set of tips, David Gardner and Tom Gardner, the authors of Motley Fool Million Dollar Portfolio did the research and found these characteristics of great funds:
- Long manager tenure. The money managers should have been with the fund for several years.
- Low expense ratio and low 12b-1 fees. These expenses eat your returns.
- Low turnover. This means the funds don’t trade their stocks, bonds, or other assets often.
One more tip, this time from Taylor Larimore and Mel Lindauer in The Boglehead’s Guide to Investing: Choose Index Funds. Index funds generally try to follow a market index, like the Standard & Poor’s 500 Index (S&P 500) or the Philippine Stock Exchange Index (PSEi). The reasoning behind it is that a lot of professionals try to beat the market (the “index”), and a lot of them fail. Due to that, it’s better to just follow the market as it performs well enough over the long run.
More about Index Funds and Passive Investing
This section was originally from the “The First Metro Index on MSCI Philippines IMI Launch” article. Since it was so important, I needed to copy the entire section about indexes and passive investing here.
Now unlike most mutual funds, index funds use a more passive style of investing. Instead of constantly buying and selling stocks to try earning more from stock movements, index funds tend to simply copy the market and they don’t trade as often. You usually won’t find these among the “big winners” reported every year, but here’s something you have to remember: “Index funds outperform approximately 80 percent of all actively managed funds over long periods of time” (The BogleHead’s Guide to Investing). For example, in the decade of 1994 to 2004, Vanguard’s flagship index fund outperformed just about 73% of all equity funds available.
What about the so-called “best funds”?
You’ll often see actively managed funds advertising that they’re the “best” and they’ll often have cool-looking graphs to prove it, but remember this: Past performance does not guarantee future returns. Just because a fund did well, that doesn’t mean it will continue to do well forever (or even in the short term). This year’s absolute best fund can become the worst loser later. Just ask my friend who bought that “amazing” fund recommended by his sister which lost a lot of value the next few months and never really recovered.
Lots of financial professionals try to predict the market to buy or sell winning stocks and other assets, but the reality is that most of them FAIL. Even the top money managers can get it wrong, and they can get it wrong often.
For example, Mark Hulbert (Hulbert Financial Digest’s editor) disclosed that the top funds, those with five-star ratings by Morningstar, failed to beat the market (1993-2000). The Wilshire 5000 (the market index) gained about 222% from 1993 to 2000, but the “top funds”, those who have five-star ratings, earned only around 106%. If you invested with them, you’d theoretically earn less than HALF what you would have gained if you chose an index fund that replicated the Wilshire 5000.
Another example? Christopher Blake an associate professor of finance (Fordham University Graduate School of Business) and Matthew Morey, an associate professor of economics at Fordham, published a study on Morningstar’s top funds from Jan. 1, 1993 to Dec. 31, 1997. What did they find? The five-star funds underperformed the market by almost 4%. What else did they find? The performance of five-star funds weren’t that much different from four and three-star funds.
We’re paying people to beat the market when they aren’t doing it, and when you think about it, that doesn’t make sense.
— John Bogle
Aside from the underperformance of actively managed funds compared to index funds in the long term, one of the greatest advantages of passive investing in general is the lower costs involved. Just imagine two similar businesses with similar earnings, but one has much lower operating costs. The one with lower costs win, especially over the long term.
Let’s apply that to investing. For example, imagine the market earns an average of about 6.5% a year and you invest P12,000 every year. A fund that costs 1.5% (thus you earn 5% a year) will eventually give you P1.45 million in 40 years. A cheaper fund that costs just 0.5% (thus you earn 6%)? You’ll end up with around P1.86 million. That’s an extra P410,000 difference by saving just one percent in fees.
*A market or investment earning a consistent 6.5% a year is only theoretical of course.
So what’s the lesson there? Instead of spending more in management and trading fees trying to beat the market and FAIL at it, it’s much better to simply follow the market and then save as much of its gains as possible through a low cost passive investing strategy.
By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
— Warren Buffett
In any case, that concludes our lesson on mutual funds for now. If you’d like to learn more, there are lots of books and articles out there that you can read next!