Thursday, July 31, 2008

An introduction to mutual funds

Stocks and bonds are both great investments. However, if you are investing in stocks, and most people should be, you need to diversify your holdings by investing in many different stocks. If you don’t diversify, you face the prospect of losing a great deal of your investment if the few stocks you own all decline. In yesterday’s example, the losses for the investment in Krispy Kreme were offset by the gains from Crocs. Imagine if all of your money had been in Krispy Kreme.

Generally, brokers charge a fee every time you buy and sell a stock. Many online brokers charge around $10 per transaction. If you are adding to your investment every month (the recommended minimum) or more often and spreading that investment between different stocks and bonds, those trading expenses could eat up most of your investment.

It is also very difficult to identify promising stocks. There are many highly paid professionals whose job is to look over the stock market and pick the best stocks for their clients. While some of these analysts consistently do well, as an industry, the results are not impressive. In fact, many studies have shown that, once you account for the fees that these professional money managers charge, the majority of them deliver returns that are worse then the average of the entire stock market. If the experts with their training, experience, and reams of data have a rough time predicting which individual stocks will be big winners, you can bet that you’ll face the same difficulties.

Stocks are a great investment, but it is very difficult, even for professionals, to separate the winners from the losers. Stocks also can be expensive to purchase if you make regular investments. This is exactly why you need to invest in mutual funds.

A mutual fund is essentially a large pool of money from many different investors. Imagine how much easier it would be to create a cost-effective diversified portfolio of hundreds of stocks using millions of dollars pooled together by thousands of investors than it would be to create a cost effective diversified portfolio by yourself. Purchases of mutual funds also have a different cost structure than purchases of stocks. When you buy shares of a mutual fund you generally pay either no fee or a fee based on a percentage of the money that you are investing. Mutual funds charge an annual fee, which is also a percentage of the money that you have invested in the fund. So rather than go through the expensive and difficult process of creating a well diversified portfolio on your own, you can simply invest in a cost effective mutual fund and own a fraction of a very large diversified portfolio.

There are as many kinds of mutual funds out there as there are flavors of ice cream. Tomorrow I will cover some of the basic types of funds and explain how you can pick funds that are right for you.

I should note that if you are interested in picking and investing in individual stocks, there is a place for them in your portfolio. I very much enjoy picking out and investing in stocks. I treat it as a hobby – the bulk of my investments are in low cost mutual funds. If you are just starting out investing, not interested in stock picking, or seeking to make your investing as easy as possible there is no reason that you would need to invest in individual stocks.

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