Mutual Funds For Dummies - Eric Tyson

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rate. From less than $1 billion in assets in 1940, fund assets grew to more than $50 billion by the late 1960s — more than a 50-fold increase. Before the early 1970s, funds focused largely on investing in stocks. Since then, however, money market mutual funds and bond mutual funds have mushroomed. They now account for about 40 percent of all mutual fund assets.

      Today, thousands of mutual funds manage about $27 trillion with exchange-traded funds holding another $7 trillion.

      Funds save you money and time

      Chances are the last thing you want to do with your free time is research where to invest your savings. If you’re like some busy people, you’ve perhaps kept your money in a bank account just to avoid the hassles. Or maybe you turned your money over to some smooth-talking broker who sold you a high-commission investment that you still don’t understand but are convinced will make you rich.

      

Mutual funds and exchange-traded funds are cheaper, more communal ways to get the investing job done. A fund spreads out the cost of extensive — and costly (for an individual) — research over thousands of investors. How does a fund save you time and money? Let me count the ways:

       Funds can produce a much better rate of return over the long haul than a dreary, boring bank or insurance company account. You can purchase them by writing a check, calling a toll-free number, or opening an account online and sending in money electronically. What does it cost to hire such high-powered talent to do all the dreadful research and analysis? A mere pittance if you select the right funds, which I help name in this book. In fact, when you invest your money in an efficiently managed fund, the cost should be less than it would be to trade individual securities on your own.

       Funds manage money efficiently through effective use of technology. Innovations in information-management tools enable funds to monitor and manage billions of dollars from millions of investors at a very low cost. In general, moving around $5 billion in securities doesn’t cost them much more than moving $500 million. Larger investments just mean a few more zeros in the computer database.

       Many funds don’t charge a commission (load) to purchase or redeem shares. Commission-free funds are called no-load funds. Such opportunities used to be rare. Fidelity and Vanguard, the two largest distributors of no-load funds today, exacted sales charges as high as 8.5 percent during the early 1970s. Even today, some mutual funds known as load funds charge you a commission for buying or selling shares in their funds. (See Chapter 7 for the complete story on fund fees.)

      Fund diversification minimizes your risk

      Diversification is a big attraction for many investors who choose mutual funds and exchange-traded funds. Here’s an example of why, which should also explain what diversification is all about: Suppose you heard that Phenomenal Pharmaceuticals developed a drug that stops cancer cells in their tracks. You run to your phone, contact your brokerage firm, and invest all your savings in shares of Phenomenal stock. Years later, the Food and Drug Administration (FDA) denies the company approval for the drug, and the company goes belly up, taking your entire nest egg with it.

      Your money would’ve been much safer in a fund. A fund may buy some shares of a promising but risky company like Phenomenal (if it met the investment objectives of the fund) without exposing investors like you to financial ruin. A fund owns stocks or bonds from dozens of companies, diversifying against the risk of bad news from any single company or sector. So when Phenomenal goes belly up, the fund may barely feel a ripple and that ripple might be offset by the shares of Terrific Telecom, in which the fund has a similarly small stake but which doubled based on its fabulous fiberoptic network.

      Diversifying like that on your own would be difficult — and expensive — unless you have a few hundred thousand dollars and a great deal of time to invest. You’d need to invest money in at least 8 to 12 different companies in various industries to ensure that your portfolio could withstand a downturn in one or more of the investments.

      Funds typically invest in 25 to 100 securities, or more. Proper diversification increases the probability that the fund receives the highest possible return at the lowest possible risk, given the objectives of the fund.

      I’m not suggesting that funds escape without share-price declines during major market downturns. For example, during the early 2000s bear market, many funds declined in value. But again, the investors who were most harmed were those who held individual stocks that, in the worst cases, ended up plummeting to zero as companies went bankrupt, or those investors who loaded up on technology and internet stocks that dropped 80 to 90 percent or more. The same fate befell investors who were overloaded with stock in financial firms like AIG, Bear Stearns, Lehman, and so on that plunged far more than the broad market averages in the late 2000s bear market. During the sharp but brief stock market slide in early 2020 caused by the government-mandated COVID-19 shutdowns, economically sensitive sectors such as airlines, cruise ship companies, and so on suffered the greatest declines a year plus into the pandemic.

Although most funds are diversified, some aren’t. For example, some stock funds, known as sector funds, invest exclusively in stocks of a single industry (for instance, healthcare). Others focus on a single country (such as India). I’m generally not a fan of such funds because of the lack of diversification and because such funds typically charge higher operating fees. It’s also worth noting that investors who bought sector funds investing exclusively in internet stocks got hammered in the technology stock crash of the early 2000s. Many of those funds dropped 80 percent or more, whereas broadly diversified funds fared far better. (The same thing happened in the late 2000s to investors in financial sector funds.) I talk more about narrowly focused stock funds in Chapter 13.

      Funds undergo regulatory scrutiny

      Before a fund can take in money from investors, the fund must go through a comprehensive review process by the Securities and Exchange Commission (SEC). After it offers shares, a fund is required to update its prospectus annually (see Chapter 8) with historical data on the fund’s returns, its operating expenses and other fees, and its rate of trading (turnover) of the fund’s investments.

      But know that government regulators aren’t perfect. Conceivably, a fund operator could try to slip through some bogus numbers, but I haven’t heard of this happening and certainly not with the reputable fund companies recommended in this book. And all funds must be audited by independent audit firms who will see their business damaged if they fail to perform their duties accurately. What has happened is that some high-risk and high-fee funds that were destined to perform poorly have been approved. Rest assured that you won’t find any such funds in this book, and you’ll also know how to sidestep them in the future by understanding the principles in this book.

      You choose your risk level

      Choosing from a huge variety of funds, you can select those that meet your financial goals and take on the kinds of risks that you’re comfortable with. Funds to choose from include

       Stock funds: If you want your money to grow over a long period of time (and you can put up

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