Earlier we saw how the stock market has performed over the course of the twentieth century. There are many stocks listed on many markets and picking the right one for your strategy can be time-consuming and deliver unsatisfactory results. The time required and the likelihood that an individual stock will perform other than anticipated drives the amount of risk upward. Generally, maximizing return while minimizing risk is a prudent course of action.Mutual funds provide a basic value to the beginning investor, not to mention a few seasoned investors. The concept is directly related to the name. Mutual means "of or pertaining to two or more." A fund is defined as "a store or stockpile of something material". It is this concept of stockpiling two or more stocks that is the strength of mutual funds. Simply, the fund collects stocks in many companies. In our risk/reward conversation we discovered that the more we group items of similarity together the lower the individual volatility and hence the risk. So in the stock market if we group forty or so stocks into a single pool (a mutual fund), that pool (fund) will perform more or less like the set of all stocks(the market).
Mutual funds use an indicator known as "beta" that reflects how that particular mutual fund (collection of stocks) mimics the market as a whole. A beta of 1 means the fund performs just like the market. A beta lower than one reflects that this particular fund responds more slowly than the market as a whole. In essence during bull-markets the less-than-one-beta fund will grow below the average rate of return for the market as a whole. But, during bear markets the less-than-one-beta fund will decline less than the market as a whole. Meanwhile, a beta of greater than one reflects "faster" growth than the market as a whole. In a bull market it grows faster than the market and in a bear market it (the more-than-one-beta fund) declines more than the market as a whole.
How to use this information is of great importance to the individual. If you are risk-adverse, perhaps you would be more comfortable with less-than-one-beta funds. If you are a strong risk taker than you might consider going with more-than-one-beta funds. If you're in-between, probably investing in funds between .9 and 1.1 beta will appeal to you. A very introductory example is this:
Previously we noted the return in the stock market in the twentieth century is 10.1 percent. Perfectly invested at a .9 beta position for the entire time period would have delivered a 9.09% return. If you were perfectly invested at a 1.1 beta level for the entire time period your rate of return for the stock market would have been 11.11%. This is an example only - perfectly invested is nearly impossible to accomplish, investing for an entire century is highly unlikely. But, nonetheless the beta measure is an important tool.
So too, is the time the fund has been in existence. Returns are reported for 1,3, 5, 10 and more years. Looking at funds with a history greater than 3 years is wise. Wiser yet is one in existence more than 5 or 10 years. Again, performance over time is the key to success. Look at the funds performance over time.
Mutual funds help you quickly manage risk. Mutual funds help you enjoy the benefits of buying a piece of a portfolio (see discussion on risk/reward). Mutual funds are structured into many specialty areas.
If you think that healthcare stocks will be star performers it is possible to buy mutual funds that position themselves in that specific industry. Many industries and special interests are structured into mutual funds. Mutual funds have managers and their individual track records can be reviewed. The manager has a staff that reviews many stocks and suggests different positions that the fund manager may implement. Hiring these people (just by buying a mutual fund) is a much safer bet than trying to do all the research on your own.
Some mutual funds are fully front-end loaded. This means they are collecting commissions essentially the same as a stock broker does on the sale of individual stocks. Other funds have "B" and "C" type versions. This means there may not be an up front commission, but if you sell the mutual fund before an agreed to timeframe, there will be a commission paid - back-end loaded is the term. The usual time periods to hold the fund are 5 or 7 years, after which the fund acts as though it were a no-load fund. This time frame is consistent with a strategy of holding investments for the long term and may very well help you discipline yourself from withdrawing money for short-term pleasures. Another note about "B" and "C" type funds: their big brother is the "A" (or front-end loaded fund) and the rate of returns reported in their prospectus and agents discussions are usually the "A" rates. Make sure you are getting the "net rate of return" for the type of fund ("A", "B", "C", etc) your are interested in holding. If you do not, invariablly you will not achieve the desired rate of return.
Finally, when you buy individual stocks on your own you pay broker's commissions. With no-load mutual funds you pay no such commissions. The fund managers get a management fee paid from the resources of the mutual fund. This means that if the annual return of a fund is 14% and the management fee is 1.5% then your net return is 12.5% (remember this when you evaluate a fund's rate of return; typically they report the market rate - not the net rate).
Why are mutual funds important? Mutual funds are the second attribute of your financial independence foundation. Most people acknowledge that the stock market provides great opportunities to acquire additional wealth. But, most individuals do not have the time or resources to spend days on end dealing with the many aspects of the stock market. Buying a mutual fund with the appropriate risk structure for you (beta), run by a team of experts (the fund manager), giving ample reward (your desired net-rate-of-return) makes a lot of sense. The cost of initial invest is relatively low, sometimes only $500 to start. Frequently the initial investment is $2,500. But, the reward over time is too great to delay. Take action - and then persist and you will reach your goals