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Investing is hard, it's nearly impossible when you're starting out. It's so hard to understand what's a good investment and what's not let alone be able to decipher what to look for in a good mutual fund. What even is that anyway?
If you're reading this, you're probably like I was when I first started, completely clueless about mutual funds. It's super confusing, there are thousands of them and all of them insist they're beating the market so it's like, what're you even gonna do with that? You get analysis paralysis and give up before you even get started.
What is a mutual fund?
A mutual fund is a collection of stocks or bonds or securities or even short-term debt that is wrapped up into one bundle that you can invest in. By investing in it, you don't own the entire fund yourself. Your money is collected along with other investors who wish to participate in the fund.
The more people invest in the fund, the more shares are created to allow people to participate in the fund. In this way, it's a little different from investing in stocks, because there isn't necessarily a definite number of shares in the fund like there is in a company you would like to invest in.
You invest in a fraction of the shares that are within the fund itself.
The problem is if you don't know what mutual funds to invest in or how to invest in general, then it's tough to decipher which are good mutual funds and which are bad ones for your portfolio.
The most popular types of mutual funds out there:
Here are 7 of the top mutual funds you should be aware of if you want to start investing in mutual funds:
- Fixed income funds:
- Buys short-term fixed rate income securities
- In English, that means they buy things that don't pay you very much for only a short span of time like 3 months, 6 months, etc. An example would be treasury bills which hardly pay you anything. Look at this table below. This is the interest rate on the money you hypothetically deposited that you would be receiving on any of these past days in June:
You could literally get almost 4 times as much than the 30-year bill just from an S&P 500 index fund.
- Equity funds: invest in mostly stocks, with a little holding in cash
- Balanced funds: own both stocks and bonds
- Specialty funds: focus on a specific industry or sector
- Funds of funds: a portfolio of other investment funds instead of directly holding stocks or bonds
- Money market funds: invests in short-term debt securities; viewed as being as safe as bank deposits, but provide a higher yield; I use this for my cash
- Index funds: tracks the index of a specific market index, like the Dow Jones or what I use, the S&P 500
I list all of these because you should be aware of all the most common mutual fund names, good or bad. It's good to know which ones you should invest in, but more importantly which mutual funds to avoid. You can dismiss every single one on there except the last two: money market funds and index funds.
Money market funds I use as it says above as a bank deposit because it's liquid, gives a better rate than the bank does, and I won't lose my investment. The S&P 500 index fund I used when I first started out and have all my 401k money in because it's the safest investment you can make for the biggest profit if you're in it for the long-term.
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What problem does a mutual fund solve for most people?
If you're like most people, you don't want to spend time researching what the best stocks are to invest in for the upcoming year. You want to live your own life and not worry about the financial markets. It's too time-consuming reading annual reports, books, newspapers, etc. Who has time to do all that on top of your day job and if you have one, raising a family?
There's simply no time in the day. So, what a mutual fund does for you is diversifies your investment into several stocks at once. Instead of deciding which company to invest in, you can invest in several at once. There are thousands of mutual funds to choose from in several different industries. It only depends on what your preference is.
Mutual Funds vs. Index Funds
Index funds are a type of mutual fund but a mutual fund isn't an index fund. You got it? Okay good. But you need to know what the difference is between mutual funds and index funds. There are two main things you need to know.
The first is mutual funds are managed by a financial professional. The financial professional is compensated for his job of running the fund. Even though 99% of actively managed funds underperform the market, they're still paid. That's a pretty good deal for them, and an awful one for you.
Index funds are passively managed, meaning they aren't run by an individual, they're essentially run on autopilot which means there's hardly a cost in fees for investing in it.
Which brings me to my second thing: mutual funds typically trade in an out of stocks of whatever particular sector they're following which draws up lots of fees at your expense. That's obviously no good. Over a year or two that doesn't seem so bad. But if you're in a mutual fund that charges over 2%, you could possibly lose literally over $1 million.
Index funds don't have that problem, AND they perform better. Always look for mutual funds with less than 1% in expense ratios. That's what the fees are called. For perspective, my S&P 500 index fund charges me only .02%.
So to recap, an index fund is a type of mutual fund because it bundles several stocks together enabling you to invest in them at once, but a mutual fund is not a type of index fund because it's actively managed by someone instead of tracking an index like the S&P 500.
Characteristics to look for:
manager tenure: this isn't that big of a deal if you're in an index fund. But if you're in a mutual fund, it would be good to see someone who's been with the fund for at least 10 years in my opinion. It's better to be safe than sorry. Typically this length is good enough to have them experience some lows and see how the fund has done. Although of course, past performance isn't indicative of future performance.
inception date: the same idea here, when the mutual fund is being compared to another fund or index, it's always better to have a larger pool to compare against. If you can only compare a year or two, that's no help. I would stay away from newer funds, especially if you come across something that's clearly a fad.
turnover rate: the turnover rate is very important before this is how often stocks are traded in and out of the fund. If there's a high frequency, you're going to incur a lot of fees that'll eat away at your performance. This industry is a lose-sum game, so you need to minimize the losses the best you can.
gross expense ratio and net expense ratio: These two are basically the fees of the fund. The lower the expense ratios, the better. My original financial advisor had me in an international mutual fund that was charging me over 2%. I had three others that were charging me over 1%. Once I knew what I was doing I sold all of them and put the money in that S&P 500 index fund with a .02% gross expense ratio. That guy should've been arrested for robbing me!
Don't follow star ratings on Morningstar
If you're trying to do research on mutual funds to see which ones are the best to invest in, stay away from Morningstar. It's ridiculous people follow that. Same with any star ratings with any brokerage firm for that matter. By the time a mutual fund is rated a four or five-star, it's too late. You missed the boat. On the other hand, if the rating is poor, you don't know if that's legit or if it's out of favor because of some economic factor that has nothing to do with the companies in the fund itself (i.e. a trade war).
Pros and Cons of index funds:
- You diversify your investment over several companies
- You don't have to constantly keep up to date on your investments
- It's not necessary to read books, newspapers, etc. to see how the world is changing companies
- You can spend more time doing what you really want to be doing
- If you know what you're doing, you'll miss out on better investments and potentially millions
That's really the only con. Index funds are so good for the average investor, especially an S&P 500 index fund, there's no reason to choose anything else. A 10% performance over 40 years is exceptional. You read people say an average performance is 7%, but that's because they take into account inflation. Either way you calculate it, you're beating every mutual fund manager over the long-term so it doesn't matter.
Who is a mutual fund good for?
A mutual fund is good for people who don't want to be overinvolved in their investments. If they want to check them, say once a year, then this is a good place to invest your money. All you need to do is make sure you invest in a mutual fund that has fees no higher than 1%. That's the general consensus experts say. But if you're asking me, I think that's because they want to seem honest but still squeeze 98 basis points (percentage points) out of you. Just stick with an S&P 500 index fund and you'll be fine.
Who is it not good for?
Like I mentioned above, mutual funds are probably not a good fit for the people who are willing to put the work in and do the research. If you have the temperament and the stamina to do the work, then, by all means, go for it. There's no sense in investing in mutual funds or index funds if you know what to do.
All in all, I think these are the best things to look for in a mutual fund. After the experience I had with my previous financial advisor, I learned firsthand how expensive mutual funds can be. Know what to look for, know the differences between good mutual funds and bad mutual funds, but just stay away from all of them except the index funds. They're the cheapest and ultimately always perform better.
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