So, you’ve heard about mutual funds, but the plethora of companies and funds is enough to leave your head spinning? That sounds familiar, for that was me not too long ago.
Mutual funds can be an intimidating investment for the beginning investor, especially for the type of person who seeks safety in banks. Just last year I was content to allow my savings to stagnate in a local bank earning 1.2% interest, which is PATHETIC! A friend convinced me to try mutual funds, given that the potential return is greatly augmented over any bank, but I was intimidated since you can lose money.
Let’s get one thing straight: Yes, you can lose money with mutual funds. In fact, you are guaranteed to, at least in the short term. The market fluctuates daily, and the value of your funds will go up and down on a daily basis as well.
First things first – there are two broad categories of mutual funds.
Loading versus no-loading:
Funds that make you pay an upfront fee whenever you buy shares are considered “loading” funds. For class “A” shares, that fee can be a nice chunk of change. American Funds currently charges a 5.75% load for each fund. Loads are mostly paid to the financial adviser, so most advisers like to “push” these funds over others, naturally. By contrast, all of the funds at Fidelity and Vanguard are “non-loading.”
Class Types:
Only “loaded” funds have classes. Class A means “front” loading – pay the load when you buy shares. Class B means “back” loading – pay the load when you sell. Class C means “continuous” loading – pay some of the load every year and probably some more when you sell. Non-loaded funds don’t have separate classes. You just simply buy shares of the fund, which is much simpler to me.
Maintenance fees:
All mutual funds have annual custodial fees. This, after all, is largely how the fund companies stay in business. To make money for all their time and effort in organizing the various funds, each fund has an expense ratio. Each year they deduct a small percentage from your funds to pay for their service and organization. This makes perfect sense to me, but where you have to be careful is in the height of the expense ratio.
Expense ratios vary between companies (and even between separate funds). For instance, the Growth Fund of America (at American Funds) has a 0.63% expense ratio, which isn’t too bad. On the other hand, the New World Fund (also at American Funds) has a solid 1% expense ratio. In this latter fund, the 1% expense ratio means that American Funds removes $10 for every $1000 you have in the fund each year. Keep in mind that the expense ratio is on top of any “load” that you have already paid.
Enter Vanguard. I currently have two non-retirement mutual funds with them. One is called STAR fund, which is a fairly-balanced fund (about 38% bonds, the rest are in stocks). It has an expense ratio of 0.35%. The other fund is a Total Stock Market Index fund, which is more aggressive. Its expense ratio is a mere 0.19%, meaning they only take out $1.90 for every $1000 invested each year. Nice!
To illustrate, if I put $10,000 into the New World Fund versus something like the Extended Market Index fund at Vanguard, in the first year American Funds would take out a total of 6.75% (load plus expense ratio), leaving me with $9325. Yikes! Vanguard would take out 0.25% over one year, leaving me with $9975. While New World Fund might have the potential for a higher return, the Vanguard fund has such a head start that it would be hard to catch.
Shares and shares alike
In addition to expense ratios, when looking for a mutual fund take a look at the cost of each share. Remember that you are purchasing shares of a fund, so you ideally want a current low share price. If I invest $10,000 in a fund whose individual share price is $100, that means I only bought 100 shares. If the price of each share goes up 8 cents one day, that means I only earn $8 that day.
If someone else invested $10,000 in that same fund a few years prior when individual shares were only $50 each, that person owns 200 shares. If the price of each share increases by 8 cents, he earns $16, twice as much as me. See now why it’s important to keep in mind the total number of shares you own versus the total value?
Any specific advice?
Yes. If you’re just getting started with mutual funds, I recommend looking at non-loading funds, such as those offered by Fidelity or Vanguard. If you can’t tell, I really like Vanguard, but I’m sure Fidelity is just as good. Look for a fund with a low expense ratio. Most “index” funds at Vanguard offer low expenses, but are best if you can invest at least $10,000. Otherwise, they deduct an additional $10 per year. In reality, this is not such a big deal, especially if you are regularly contributing to the fund. (UPDATE: Vanguard has eliminated fees for low balances, provided that you choose to receive online statements.) I own one index fund, and I’m nowhere close to $10,000 yet, but I hope to be within the next year or two.
Almost every Vanguard fund has a $3,000 minimum investment per fund. If you do not have that much yet, you only have one choice: the Vanguard STAR fund, which has a $1,000 minimum investment. I first bought shares of STAR because I was intimidated by mutual funds in general and did not want to jump in all at once.
You can see a current list of all Vanguard funds here, along with their share prices and earnings.
Final Thoughts
No matter what fund you choose, buy shares of it and forget about it. Resist the urge to check it daily to see how much you gained/lost. The funds I own have earned at least 10% since inception, so no matter the short-term ups and downs, it’s better to focus on the long haul.