It’s a beautiful Saturday afternoon and you flip on the television to watch some college football. A commercial comes on which depicts an older guy skipping in some flowers with his grandkids down to a gorgeous lake. They are smiling and carrying fishing poles. A deer walks over without a care in the world and they get to feed it with some of the food they have brought along. Birds are singing, magic is in the air. Then a voice comes overs and says, “The life you desire is in your reach. With the right mix of mutual funds provided by “insert firm name here” you can have that life and enjoy moments like this with your grandkids. Talk to an advisor today.”
Now I obviously sugarcoated this ad a bit but I’m not actually too far off from a typical commercial you will see. Brokerage firms WANT your assets and they need to portray the lifestyle you want to get your business. Many of them, like in the ad above, push mutual funds as a top product that you should invest in. In this article, I’m going to be breaking down what a mutual fund is and how it might not be best for you.
I like to think of a mutual fund like a breakfast crunchwrap from Taco Bell. Think of your eggs, bacon, sausage, hash browns, gravy, and cheese all being different stocks. They are all put together and wrapped in a tortilla to make them one product that you can buy, the breakfast crunchwrap (mutual fund). A mutual fund is just a pool of stocks brought together and have a money manager that controls the fund. The mutual fund’s price is based off how the stocks within the fund are doing as a whole. For example, let’s say a mutual fund was composed of ten stocks, IBM, McDonalds, Amazon, Best Buy, Apple, Ford, Microsoft, Netflix, Disney, and Twitter. The funds price is going to be determined as an aggregate of how all ten did on the day.
The most common reason investors like mutual funds is for the instant diversification it gives you. Remember how we talked about risk management as being the holy grail of trading? Well with mutual funds you are spreading your protection among a variety of different stocks, immediately protecting yourself more if there was downside movement. Think about our fake fund from above. If Amazon suddenly tanks one day, your account will not be taking a severe hit because it only one piece of the puzzle. Other stocks like Netflix and Disney might be up at that same time which will balance out the fund itself.
One of the main differences between mutual funds and stocks is that their price is only calculated once per day. While stocks trade all throughout the day, mutual funds get calculated once after the market closes. This means that if you want to buy or sell you won’t know what price you are getting till the market closes. Mutual funds still trade in shares just like stocks and their value is what’s known as the NAV (net asset value). So, let’s say you like the fund from about and want to invest 5k into it. You put an order in to buy and after the market closes the NAV is calculated to be $25.67 for the day. If this is the case, you would buy approximately 194 shares (5,000/25.67).
If you hold a 401k plan with your work you probably are invested in mutual funds, whether you’re aware of it or not. In fact, at the time of this writing, there are over 15 trillion dollars in mutual funds. Investment firms pitch them all the time and rating companies give them 5 stars to make you think that they are some of the best products that you can get into. They tell you they will outperform the market and give you outstanding returns on your money. But get this, 96% of mutual funds fail to beat the market over a sustained period of time!
When I say fail to beat the market I am talking about a stock index. Remember we talked about those in the article, Myth 1: Only Experts Can Trade Successful in the Stock Market. To refresh your memory, they are just a basket of stocks that give us a good gauge of how the market is doing as a whole. The Dow Jones and S&P 500 are examples of indexes. These mutual fund managers are attracting your business to their funds because they are telling you that the fund will beat the market aka give you higher returns. Now read the second part of that statistic, “over a sustained period of time.” What this means is that the fund may outperform the market one year but it could also severely underperform it another year. In the past 5 years, the S&P 500 has been up an astounding 72%! I’d like to see a mutual fund outperform that.
Here is the kicker with mutual funds. Remember that a money manager is controlling the fund. Often there will be fees involved that you will never see with stocks. Let’s take a look at a list of possible fees:
- Front-End Load Fee
- Back-End Load Fee
- 12b-1 Fee
- Short-term redemption fee
- Transaction fee
- Contingent Redemption fee
I wouldn’t worry what these fees mean because you should not be paying them. The average cost of owning a mutual fund is over 3.17% per year! We want to utilize the power of compounding more than anything. If we are getting returns of 10% annually every year but we are paying 3.17% in fees, we are drastically cutting into how much money we can make long-term. Let’s take an example to see just how much money we’re talking about.
Ron and Tim both decide to invest in some mutual funds. Ron buys a fund that is about 1% in fees while Tim buys a fund that is 3% in fees. Both invest 100k into the funds and for the sake of this example let’s say they are getting an annualized return of 10%.
|10 Years Later||20 Years Later||30 Years Later|
|Ron @1% fees||$236,836||$560,441||$1,326,767|
|Tim @3% fees||$196,715||$386,968||$761,225|
As you can see there is over half a million dollars difference after 30 years! Fees add up guys! There is no reason you should not be paying for them.
If you are going to invest in a mutual fund, make sure you know how much you will be paying in fees. Anything above 1% is not worth your time. If you have a 401k plan I would suggest you find out how much you are paying in mutual fund fees. It could be eating away at your returns and you don’t even know it!
If you still want to reap the benefits of diversification that mutual funds give you then consider index funds. Index funds are what we talked about before. They follow indexes like the S&P 500 which has grown 72% the past 5 years. It’s going to be hard to beat that. You will find that Vanguard provides many of these index funds with expenses of just 0.17%. Now that is more like it. A very popular one is the Vanguard S&P500 index fund, ticker symbol VFINX. It has outpaced actively managed funds by 80% the past 5 years.
Homework: If you have a 401k or 403b plan find out what it is invested in. I guarantee most of you have no idea. Ask your HR department if there is not an online portal to go through. Look up the mutual funds that your money is invested in and see how much you are paying each year. Remember from the chart about that extra 2% could mean missing out on half a million dollars!