A Guide to Mutual Funds for People Who Don’t Speak Wall Street
This article was reviewed by Robin Hartill, CFP®.
If we could go back in time, we’d all buy Apple, Netflix and Amazon when they were less than $25 a share.
Heck, we’d buy them at $100 a share. But when a company’s stock is that low, it’s nearly impossible to know whether it’s going to make you a fortune or be the next to go bust.
Likewise, by the time you’re ready to save for retirement, Amazon is soaring to more than $3,000 per share, and there aren’t enough hours in the day to study all the stocks you’d need for a diversified portfolio that will weather the storms of the market.
Compiling an investment portfolio would be like taking on a second job.
Thankfully, the mutual fund was created so people could invest without being experts on individual stocks.
What Is a Mutual Fund?
A mutual fund is a pool of investments that’s mutually funded by a group of people.
That pool can buy a portfolio that includes stocks, bonds, index funds, cash equivalents like CDs or a combination of the these. The risk of investing in a mutual fund is lower compared with investing in just one or two stocks. And most mutual funds are actively managed by someone or several people who balance the portfolio for you as stocks rise and fall.
The modern mutual fund aims to beat the market. In a perfect world, fund managers would pick only the fastest-growing companies and know all other companies on the rise so they could switch out slower performers for promising newcomers.
You’re probably like, “So they have to be psychics?”
Yes and no.
Managers spend much of their time studying the companies they include in your investments. It’s illegal to get information from those companies before the public knows. (That’s called insider trading, and it’s why dear Martha Stewart did a stint in prison.)
So with not much more information available to them than you can get through a Google search, their picks are little more than educated guesses.
Advantages and Disadvantages of Mutual Funds
Mutual funds are a done-for-you investment strategy. A “set-it-and-forget-it” method for investing.
But with all done-for-you services, you pay a premium for convenience. That premium shows up masked as the commissions, fees and other charges associated with the fund.
Let’s break them down.
Load: A “load” in mutual fund speak is a sales charge or commission. When you invest through certain brokers, financial planners or investment advisers, they’re paid off the top of every deposit you make into your mutual fund.
If you’re confused as to whether you have one of these, they’re labeled as Class A shares in your portfolio. For mutual funds made up of mostly stocks, the average load is 5.4%. That means if you invest $1,000, whoever sold you the fund gets $54, and $946 gets invested.
These loads get smaller as you invest more but usually don’t go away until you have $1 million invested.
Hiring costs, aka management fees: An annual or quarterly fee usually between 0.5% and 1.5% of everything you have invested in the mutual fund.
So let’s say you invest $25,000 a year into a mutual fund with a 5.4% load and 1% management fee. That means $23,650 will be invested into the fund, and a minimum of $236.50 will be deducted for management. That’s not taking into consideration 1% on any growth the fund sees in that year.
Also, it’s a good time to note the management fee is not the management expense ratio (MER). The MER is an overall average of your expenses/fees and will be higher than the management fee.
12b-1 (aka Marketing Fees): Did you know the investors pay for the marketing and promotion expenses of a mutual fund? Yep. If you see a 12b-1 fee, that’s what you’re paying for! Not all funds have this, but on average, it’s an annual fee of 0.13%.
These are just the tip of the mutual fund fee iceberg.
How to Buy Mutual Funds Without All The Fees
Not all mutual funds are created equal. There are alternatives that are low-cost, easy to understand, and often yield even better results.
Mutual Fund Companies With No-Load Funds
Mutual funds sold without a commission or sales charge are, you guessed it, no-load. They are the same actively managed mutual funds, but they’re purchased directly from the investment company.
You might recognize names such as Vanguard, Fidelity, T. Rowe Price, and Schwab. These are mutual fund companies. You can go straight to their websites, open a brokerage account and start investing in their mutual funds.
Index funds are mutual funds that aren’t actively managed. Hence, no advisers make a commission on them, and you don’t have any managers to pay, making the average expense ratio on an equity index fund 0.09%.
Index funds aren’t designed to beat the market. They’re filled with equities that will mirror the market. Without all the fees, your principle is able to generate more compounding earnings. Plus, actively managed funds usually don’t beat the market, so you shouldn’t be afraid of their passive management style.
When you invest in an actively managed fund, you’re typically invested in just one mutual fund that changes over time. Because the makeup of index funds rarely changes, most experts recommend having several in your portfolio.
Not all investment advisers are created equal, either. If you want someone to guide you in the investing process, but don’t want the high fees associated with most mutual funds, there are fee-only advisers.
Fee-only financial advisers — not the same as fee-based — charge an hourly rate or monthly retainer for their services. They don’t take commissions, so they can be impartial to any particular fund.
You pay them $150 to $300 per hour, and they will assemble the best — and cheapest — portfolio for you, personalized to your life goals.
If you can’t wrap your head around all the information you find in a Google search, spending $400 to $900 on professional advice is way cheaper in the long run than 1% of your lifetime earnings.
Just know that the best candidates for financial advising typically make $150,000 annually or have at least $250,000 already invested, so don’t feel like it’s a necessity to start investing.
A much cheaper option is robo-investing. A computer algorithm will choose the best mix of investments for you based on your age, risk tolerance and when you want to retire.
If you’re just getting started, make sure you’re contributing up to your company’s match in your 401(k) plan. Check the options, and choose the fund or funds with the lowest fees.
Jen Smith is a former staff writer at The Penny Hoarder.