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Tuesday, January 19, 2010

Mutual Fund 101 (The Basics) - Part I

A good friend of mine called recently to ask for advice about what to do with an inheritance. During the call, I realized that while there are many books that describe mutual funds, few actually give it to you straight: here was a gap that needed to be filled. This advice, then, explains the major types of mutual funds, who should buy them, and when. First, you will need to know a few essential terms.

Mutual Fund –A mutual fund is simply a collection of items that you can purchase as a single unit. Say for example, that you have $5000 that you would like to invest in oil and gas companies. One choice would be to buy $5000 worth of stock from a single oil company; however, if that company has financial problems you will lose money. A second option would be to diversify by purchasing $500 worth of stock from 10 different oil and gas companies; however, the purchase fees would be high and the stocks hard to keep track of. The easiest option is to simply buy $5000 worth of “ABC oil and gas fund,” which contains stocks from 10 or 20 companies. Your money is pooled with that of other investors, so that you can diversify while spending a minimal amount of money. And, there is no need to keep track of all the companies, since the mutual fund manager does that for you.

Time Horizon – The number of years before you will need the money you are investing. Misjudging time horizon is probably the most common error that investors make. Every year I ask people, “How soon will you need this money?” All too often I hear, “I probably don’t need it for 10 years or so. But I want to put it in GICs, because I don’t like the market, and I don’t want to lock it in for more than 2 years in case I need it.” This is fear talking. Fear causes you to make stupid financial decisions (such as, in this case, repeatedly buying 2-year GICs that pay a low interest rate). Do yourself a favor. Set aside 3 month’s worth of salary in a savings account, and label it “emergency money.” There. Now, any additional money that you have, you can invest according to your real time horizon without excuses.

Market Cycle – the predictable up and down waves of the economy and market sentiment that drive stock prices. The market cycles are: Post Crash (“have we hit bottom?”), Recovery, Growth, High-growth/Boom (great economic headlines), Bubble, and Crash. You can roughly determine which area of the economic cycle we are in by watching the evening business news, since they will use these phrases exactly. For example, in the recovery phase, you will hear things like, “some analysts say the economy is recovering, but so-and-so disagrees.” During the bubble phase, analysts will be arguing about whether or not there is a bubble. It’s all quite obvious, once you start looking.

MER – Management Expense Ratio. The MER is the fee you pay your mutual fund manager, as well as costs for advertising and administration. Simple funds that don’t take a lot of work to manage will have a low MER (less than 1%), while funds that are more complex will have a higher MER (more than 2%). MERs make a big difference to long-term gains. Say, for example, that you invest $10,000 in each of two funds, one of which has a low MER of .80% (Fund A), and another that has a high MER of 2.00% (Fund B). Both funds make a 10% return every year before expenses, and are otherwise identical. At the end of 10 years, your $10,000 investment in Fund A will be worth $24,111, while your investment in fund B will be worth only $21,985 (a $2126, or 9.6% difference). The longer the time invested, the bigger this gap gets. Generally speaking, high MER funds do not outperform low MER funds. In other words, you don’t get what you pay for.

Volatility – Volatility is the degree to which your investments will fluctuate in price. In the long run, investments trend toward an increase in value. But, they will go up and down, regularly, like the seasons. Retail Investors (non-pros) are infamous for having no tolerance for any decline in the value of their investments. Partially this is due to ignorance (being unaware of market cycles, and thinking that their investments have suddenly “gone bad”), and partially due to fear (“Now I’ll never retire!”). If you invest in stocks, they will be volatile. True professionals don’t always avoid volatility; they just don’t mind it when it happens. The greatest professionals love it and take advantage of it.

Loads/Deferred Sales Charges – Front-end loads are fees that you pay for the “privilege” of buying a mutual fund, while deferred sales charges or back-end loads are fees that you pay when you sell your funds. If you sell your funds too soon -- say within 7 years -- you have to pay a clawback penalty. Depending on the size of your investment, these charges can be hundreds or even thousands of dollars. Back-end loads are called “rear-end loads” by pros to express their effect on clients, which pretty much says it all. Since there are so many great funds available without charges (called no-load funds), simply don’t buy funds that have them. Always ask, “Does this fund have any front- or back-end loads, or deferred charges of any kind?” If the answer is “yes,” you are about to be screwed.

Well, now that you have a foundation for understanding mutual funds, the next step is to review the types of mutual funds and when to buy them! Part II awaits!