This post was written by Shane Linart, a Field Education Representative at Colorado PERA. If you'd like to submit a guest post, email us at email@example.com.
I have a confession to make. My first personal investment was ten shares of stock in Enron in late 2000. In less than one year my ten shares (also my life savings to that point) were worth nothing. This is how I learned to love mutual funds. The following are four characteristics of mutual funds that can transform poor investors like me into good ones. I wish I had known about mutual funds before I had sent my life savings off to die.
Mutual funds allow individual investors to purchase investments like large investors.
According to a 2013 study by Fidelity Investments the average annual contribution into a 401(k) during 2012 was $2,733 or, $227.75 each month. When an investor goes shopping with that money, they are severely limited by both what is available for the money and the transaction costs associated with buying an investment. A $227.75 contribution would not buy even one half of a share of APPL.
In a mutual fund, the investor buys shares in the fund and not the underlying investments. New contributions are then pooled with the new contributions of thousands of other investors. This allows an investor access to a broad range of choices and reduces transaction costs based on the volume created by the pooled money.
Pooled resources allow for greater diversification.
Diversification is one of the pillars of a successful investment strategy. All investments have some type of risk attached to them and may react differently to the same market conditions. This includes investments that appear extremely similar. Outside of having a crystal ball, a broad diversification is the best defense against these risks, even when the two investments may appear identical.
Think of it this way: In the 1980s there were three companies that were defining the personal computer market. Tandy, Commodore International, and Apple Computers. As of today Tandy is barely in business and no longer makes computers, Commodore International ceased to exist in 1994, and Apple Computers is among the most valuable companies in the world. Yet in 1980 it would have been difficult to know which was which. With the powerful diversification found in a mutual fund an individual investor would have had access to all three companies and spread the risk, realize the gains of the successful and minimizing the losses of the failures.
The investment strategy, research, and execution are handled by professionals.
Chances are that you are trained, paid and experienced in just about anything but investing. Active investing is difficult to say the least. Imagine sifting through the 2,800 companies that reside on the New York Stock Exchange alone. Finding the winning stock in that pile and at the right time takes serious time and energy. Mutual funds have a team of professionals whose sole job and training is to select investments that meet a previously agreed upon strategy. Is there still work to be done by the investor? Of course there is. It is still up to the investor to make decisions in choosing from the many strategies available in mutual funds, the investor just doesn’t have to do the tough work of choosing the actual investments.
The fund management team can potentially make judgment calls about the underlying investments in a mutual fund. If the team noticed that Commodore Computers was no longer a good investment they can mitigate losses. If the team’s research indicates that Apple Computers is the next big thing, they can increase exposure to the future gains of the company. This all requires a specialized set of skills and access to a constant stream of information.
Mutual funds give the individual investor access to a broader spectrum of the investment world than they would have on their own.
The U.S. stock market only makes up about 33% of the world’s total stock market capitalization. There is a fair amount of growth to be had in the rest of the world these days. Yet, as an individual investor it is highly unlikely that one could affordably access these investments or even find them. Mutual funds may allow for investment in commodities like corn or oil that would normally require access to storage and transportation to own and trade directly. A mutual fund can give an individual investor access to real estate portfolios that would require millions of dollars in capital on the open market.
The point here is that mutual funds allow an individual investor to further expand diversification principals while gaining access to areas of potential growth that they never would have had before, whether it is international, commodities, or real estate.
So what’s the lesson here?
Through the use of mutual funds even the most amateur investor can remove some of the biggest mistakes a person can make when investing money. Mutual funds diversify by nature, they make sure the investor is getting the most bang for their buck, investments are picked by those who know what they are doing, and they offer access to previously inaccessible asset classes. Do mutual funds remove all of these risks? Certainly not, but they give us amateurs a good start.