It used to be difficult for investors of modest means to thoroughly diversify their portfolio. Putting together the right mix of individual stocks and bonds can be expensive.
Hence, the birth of the mutual fund industry.
Because they pool the resources of thousands of investors, mutual funds give any individual the wherewithal to possess hundreds of stocks. But over the years, a host of myths have grown up around mutual fund investing. And if you believe them, you could find yourself one unsatisfied investor.
It's difficult for human beings to avoid the herd mentality. After all, we're social animals and as such, we take our behavioral cues from others.
This lemming-like tendency is especially pronounced when it comes to mutual fund investing, which by its nature attracts investors who like to leave the analysis to others. However, no matter what your investment goals or time horizon, you should always apply your own rational analysis when it comes to your savings.
[InvestingAnswers Feature: Find The Best Target-Date Mutual Funds For Retirement]
As you analyze the plethora of mutual fund alternatives, don't fall for what may be the three most prevalent mutual fund myths:
1) Mutual funds always are long-term investments, suitable for retirement. Invest in them and forget them, until you need the money.
This is false! Many fund managers run their respective funds with short-term goals in mind. If you don't regularly monitor your fund and change course when warranted, you could be left holding the bag.
2) As fund assets increase, mutual fund costs will decline.
For most funds, this has yet to occur. As they've grown bigger, many funds continue charging higher and higher fees.
The investment industry continually pushes the myth that the statistical law of large volumes, when applied to mutual funds, will protect the average individual investor from paying too much. The theory says as a fund's assets expand, each individual becomes responsible for a shrinking percentage of the fund's fixed costs. In reality, expenses for many funds have gone only one direction: UP.
3) Taken as a whole, mutual fund returns meet the expectations of investors.
Not true. Indeed, a majority of funds don't even reach their benchmark index.
Reality Checks
When looking at mutual funds, apply a few 'reality checks' to make sure you understand what you’re getting into. Here are some of the fund characteristics you should scrutinize:
1) The fund manager's investment strategy and whether or not it is relevant to your investment needs.
The fund manager's investment strategy can be found in the fund's prospectus, usually on one of the first few pages. Make sure it's a strategy that you agree with and that serves your needs.
For example, if you're invested in a mutual fund for your retirement, the fund should be conservative and suitable for long-term investors.
2) The fund's expense ratio, also stated in the fund prospectus.
The fund's expense ratio is its annual operating expenses divided by its average annual net assets. An expense ratio is the percentage of your assets a fund claws back each year as payment for its services. Most analysts consider an expense ratio of 1 percent or less to be reasonable.
3) Fund performance over three different time periods: the past year, past five years, and since inception.
A manager might get lucky over a short time frame, but if you use longer yardsticks, you'll be able to separate true talent from sheer luck.
4) Portfolio turnover, as stated in the prospectus.
Keep a special eye out for unnecessary turnover within the fund.
According to industry analysts, in recent years fund managers have racked up an all-fund average turnover of more than 100 percent. In other words, in the aggregate, managers sold all the shares that they owned at the beginning of the year and bought new ones.
This sort of intense trading exposes you to the twin enemies of investing profits: income taxes and trading expenses. Industry experts estimate that trading expenses sock investors for between 0.7 percent and 2.0 percent every year, and income taxes can eat up another 0.7 to 2.7 percent, depending on your particular tax bracket. Add up all of these hidden costs, and they can take a big bite out of your potential gains.
Take care to screen all funds for unreasonable turnover ratios. If you pinpoint a fund that sports a turnover rate of 50 percent or more, calculate whether its returns are higher than funds with lower turnover rates. Keep in mind the time periods involved and whether these returns were consistent. If you take the time to look, you can find plenty of low turnover funds that won't rack up unnecessary costs and fees by 'churning and burning' your holdings.
