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Money Matters MUTUAL FUNDS FOR INVESTMENT SUCCESSBy MARY LYNNE DAHL, Certified Financial Planner™
January 25, 2014
The answer, for ordinary people, is usually to start with mutual funds. Set a goal for how much cash you can invest and divide that amount by 12 and begin by investing that amount every month for a year. Repeat that the following year and continue until you reach a long term goal. When setting a long term goal, it helps to be very specific and target a goal that has a purpose, like retirement. A good tip to be aware of is that for every $5,000 of income you will need in retirement, you should have accumulated about $100,000 in principal in your nest egg. If you do not adhere to this rule of thumb, you risk running out of money by overspending this nest egg. The reason for this is that you do not know how long you will live during retirement. People are living to much older ages now than in the past, so we all need more money to be able to produce the income during those years. A mutual fund is the everyday term for what is formally called a “regulated investment company”. Mutual funds are suitable for most ordinary investors because they provide wide diversification, automatic reinvestment of the earnings of the stocks and bonds in the fund and are invested with specific goals in mind so that investors can select funds that meet their own goals and because they do not require large amounts of money in many cases. In addition, they offer a systematic method of investing called “dollar cost averaging”, which has proven to increase the potential gains and reduce the risks slightly. There are a lot of good quality, well-managed mutual funds that allow individual investors to open an account with very small amounts of money, such as only $100.This is not possible with stocks and bonds purchased in shares, as one share may cost that much or even more, and it is not cost-efficient to buy just one share of a stock. It is, however, efficient to buy $100 worth of a mutual fund. With a mutual fund, you own shares in the fund, which in turn owns shares in many stocks. One of the keys to investing in mutual funds is to control the costs of buying or selling the shares in your mutual fund account. The lower the costs of owning your mutual fund, the more your fund will grow in value over time. There are several kinds of costs associated with owning shares of a mutual fund. The first cost to investors is called a “load”. This cost is a sales commission paid to a broker who acts as the salesperson offering you the fund. It is possible to pay as much as 4% - 6% to the salesperson or as little as 0%. A fund that charges you a load when you buy shares is called a “front loaded fund” and a fund that charges you a load when you sell them is called a “back loaded fund”. You can, however, pay nothing by buying shares that charge nothing when you buy and sell; this is called a “no load fund”. All mutual funds are required by law to disclose whether or not they charge a load of any amount and any salesperson suggesting you buy shares must disclose his or her commission from the load the suggested fund will charge you. Another kind of cost associated with owning shares in a mutual fund is what is called the “expense ratio”. This is an amount that measures how much the fund in question spends on its routine operation as a business. The lower the expense ratio, the more efficiently the fund is managed and the less that they spend on operation of their business, which means that more of the earnings of the fund pass along to you, the investor. The less you pay in costs, the more you invest. Some funds also have a third type of cost, called a “12-b-1 fee”, which is an ongoing load charged continuously. Just like a front or back load, funds and salespeople offering funds must disclose to you, prior to your purchase of shares, whether or not the fund charges a “12-b’1” fee. Obviously, to be a successful investor over the long term, it is to your advantage to pay the least amount in costs to buy, own and sell shares in your mutual funds. The less you spend, the more that gets invested in stocks and bonds and the better your chances of potential profits and accumulation of value. Another key to successful mutual fund investing is in selecting funds that suit your goals, have good management and which match your tolerance for risk. How do you select funds that meet these criteria? There are several ways to do this. One is to get competent, professional investment advice, not from a sales person who will make a commission on his or her recommendations, but from an advisor who is objective because he or she does not make a commission for any recommendations. This is called the “conflict of interest rule”. Advisors who do not have a conflict of interest are required to act in your best interests, not in their own interest. If you are a do-it-yourself investor, you may want to select your mutual funds without advice. In this case, you should be prepared to do some research. A great source of mutual fund data, with research information that you can trust, is a company called Morningstar. This company gathers and publishes reliable information about almost all mutual funds available to investors. At last count, there were over 25,000 mutual funds in existence, so that is a lot of research and data to provide. Morningstar rates the quality of funds, measures the risk level on each fund, categorizes them by investment style and purpose, tracks their performance over time, notes their earnings from interest, dividends and capital gains and specifies the costs associated with each fund individually. It also compares funds with peer groups. You can generally rely on the information from Morningstar and choose a fund or funds that will work in your situation, but using this kind of data service does require some education on your own part. Most professional advisors use Morningstar data, as well as other companies such as Ibbotson, Bloomberg, Ned Davis, and bond rating services, among others. The general goal of investing in a mutual fund is to accumulate more shares over time and for those shares to produce earnings while also going up in value. Below is an example of how to accumulate shares using the “dollar cost averaging” method of investing every month. This is how it would work: you invest $250 in a fund on the 10th of every month, automatically. Dollar Cost Averaging Example of $250 invested every month:
By using this method, you reduce the cost of buying all your shares at a high price, such as Month 1 or Months 9-12. No one can predict when shares prices will fall or rise. This method reduces risk and increases overall potential for gains over long periods of time, such as 10 or 20 years. In addition, it offers the convenience of planning your investment using a budget, such as $250 per month that you commit to invest. It works well for most people, and is ideally suited to mutual funds as an investment tool. If you are very young, lucky you! You have the advantage of many years to invest, using this method. You stand a very good chance of reaching your financial goals! But even if you are not young, investing in mutual funds is a very good method of diversifying your invested dollars, producing income for retirement, reducing the risks associated with stocks and bonds and preserving your hard-earned financial security. In over 30 years as a certified financial planner, I have never once had a client tell me that he or she wished they had invested less or started later. It’s always the opposite. If mutual funds seem like a choice that could work for you, get started today! Make 2014 the year you become a serious investor.
©2013 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only. Mary Lynne Dahl©2014
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