In the previous step we looked at the advantages and challenges of choosing the shares and bonds to invest in yourself. In this new step we look at an alternative which is designed to help you if you don’t want to choose your own investments, but rather rely on the opinion and experience of somebody else: Investing through collective or mutual funds.
As we’ll see, this type of investing has its own major positives and drawbacks so let’s get started with the details.
Mutual funds – an overview
In the case of collective or mutual funds, the money of small investors in pooled together in order to raise the total amount available to invest. A fund manager is appointed to manage these funds and he or she decides which shares and bonds to add to the portfolio, trying to make as much money as possible. This often means they buy and sell continuously, following the market, aiming to buy shares at a low price, sell them at a high price and rush selling if they see a fall in the market coming, to avoid their clients losing a lot of money. Sounds like a good tactic? On paper yes, but in reality there are two main problems with this type of investing.
Firstly there is the claim that many mutual fund managers make that they can beat the market. This is a great promise, but how likely are they to actually live up to this promise? Many research and case studies suggest that mutual funds are unlikely to get better returns than the average of the market over long periods of time. There are indeed many funds that get better results, but even if they do so for several years, they are unlikely to maintain their success. Many books have been written on the topic, and even famous investors and fund managers have admitted that mutual funds are unlikely to give the investors good returns continuously. A fund doing well now, might well be performing far below average in a few years. In reality, fund managers are unlikely to be able to predict what is going to happen on the market and if they are lucky a few years in a row to get good results, their funds will likely not be able to continue doing so.
A second mayor problem with mutual funds is the tremendous amounts of fees that you end up paying, so this is a much more expensive way to invest. Let’s look at some of the costs you might be charged for:
- Management fees – these are in essence the fund manager’s salary as well as the costs the company has to run and manage the fund.
- Trading costs – every time you buy or sell on the stock market there is a trading cost, that you are charged for.
- Load fees – these costs are in essence sales commissions for the fund manager every time they buy or sell a share. Not all mutual funds have load fees, but many do and these can be as high as 5-6%.
- Taxes – every time you sell your assets, the virtual capital becomes actual money, which means that you have to pay taxes. Whereas if you opt for a buy-and-hold strategy, where you don’t sell any shares or bonds regularly, you don’t pay taxes until the moment you decide to sell and thus generate an income.
As you can see, the more often shares are traded, the higher the costs for you as the investor, as each time you buy or sell you pay trading costs, load fees and taxes. But the whole problem with mutual funds is that shares are bought and sold continuously, all the time. Hardly any fund ends a year with the same shares as the one they started off with at the beginning of the year. This continuous trading is needed as according to the managers this is how they beat the market. But whether that constant trading is really in the interest of the investors remains the question. An additional problem is that many of the above costs are not stipulated anywhere and often hidden behind layers of complexities and jargon used by the mutual fund companies, so that investors are unlikely to even notice.
In summary, mutual funds have the following pros and cons:
- over short-term periods ( 1 – 5 years), mutual funds can outperform the market and get very good returns.
- you don’t have to make (many) investment decisions, the fund manager will determine what to invest in and when to buy or sell.
- Mutual funds have many costs and fees, some hidden and some open, that can eat away any returns and investors’ money quickly
- over long periods of time, a mutual fund is extremely unlikely to outperform the market.
- many mutual funds specialize in a segment of the market, meaning portfolios are often not very diversified.
Many books have been written about this topic with far more detailed reviews of mutual funds and I strongly recommend you read a few books on investing to inform yourself well of all the advantages and disadvantages in greater detail to help you make wise decisions about your money. The information above is merely a very basic introduction to the concept of mutual funds.
Step 51 – Investing through Mutual Funds – in detail:
Depending on where in the world you live, the costs and funds available can vary significantly, so it is worthwhile finding out what specific options are available to you.
- Look for various (at least three or four so you can compare them well) mutual funds in your country.
- Try and find out as much as possible about the following details and make an overview per fund so you can compare them quickly:
- annual management fees
- trading fees, commissions, advertising fees and load fees. (you are unlikely to find any information here though as most mutual funds don’t stipulate these costs anywhere and simple charge you for them without really notifying you).
- types of funds available, i.e. small-companies fund, aggressive fund, offensive fund (with more bonds) etc.
- performance history of the fund – remember that any past results are no guarantee for future results
- general information on company offering the fund as well as the fund manager(s).
- Have a quick look at your overview and remember that even if the fees sound small to you, 1,5% can quickly add up to several thousands of dollars over longer periods of time that you end up paying for.
Rests us one last option of investing, which we will look at in the next step. You might think by now that investing isn’t really something you’d like to ever do due to all the disadvantages described before, but hopefully you’ll find that the third option of investing (through index funds) offers a great alternative to the two methods described before.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.