Mutual Fund Investing: What is it, and is it right for you?
If you invest your money with a financial advisor, check your most recent statement. Almost half of all US households invest in a mutual fund. You are probably one of those people. You should know what they are and why they exist in the first place.
So we are on the same page, let me give you a very formal definition of a mutual fund: a bunch of stocks lumped together as a single investment. True, funds can include other securities like bonds, real estate, or more, but for the sake of this article, let’s go with my formal definition of a bunch of stocks.
The first mutual fund was created in 1924 right here in Boston by a company now known as MFS Investment Management. The rationale was simple: you get access to complex investments by pooling your money with thousands of other people.
I love the rationale behind investing in a mutual fund. The problem is, about 30 years ago Wall Street learned they could make a LOT of money creating mutual funds, and now the cost of investing in them far outweighs the benefit. Here are a few reasons why we at Beck Bode don’t invest in mutual funds for ourselves or our clients.
Mutual funds aren’t designed for you.
They aren’t personalized. You invest in the same mutual fund thousands of others invest in. Just like a diet written in a health magazine, it may work ok for you, but a personalized plan for you specifically would be a whole lot better.
They also have rules they need to follow that are, unfortunately, designed to protect the companies that created them from lawsuits, but those rules affect your bottom line. For example, many funds only allow a stock within the fund to represent a maximum of 5% of the overall value of the fund.
Let’s say, for example, you owned a fund since 2003, and Apple was one of the stocks within the fund. In early 2003, Apple was selling for about $1/share. It now sells for about $162/share. Over the last 14 years, if your mutual fund only allowed Apple to represent a maximum of 5% of the fund’s total value, your fund manager has had to sell Apple shares to maintain that balance despite Apple’s explosive growth.
Why sell shares of a growing stock?
Because by keeping Apple at a maximum of 5% of the fund’s value, it ensures you are “protected” and not overly invested in any one company….even though that diversification cost you thousands if not tens or hundreds of thousands of dollars in potential earnings.
“Di-worse-ification” is real.
I went to Morningstar’s website and looked at a few of Fidelity’s 5 star funds (5 star funds are Morningstar’s way of rating mutual funds, 5 being the best.), and they contained anywhere from about 150-2,000+ companies per fund. Now, consider that people typically own anywhere from 3-8+ funds in their portfolios.
Conservatively, that means you own anywhere from 450 to 1,200 companies at one time. At that volume, your investment in each company is so diluted, even if one stock skyrockets there’s no way you will capitalize on the company’s gains.
Mutual funds are a product, and products make money for their creators.
Let’s face it, MFS didn’t create the mutual fund to be the “good guys” on Wall Street. They know investing is emotional. By investing in one fund, you can simultaneously own hundreds of companies AND keep your risk at a minimum. It sounds like a no brainer, right?
Here’s the catch - the fund is designed to make THEM money while keeping you emotionally pacified. Aside from the fees associated with the fund, which may be enough to dissuade an investor, let’s look at the history of mutual funds and see what we can extrapolate.
It’s no coincidence that in 1981, when the 401k plan was created, the total number of mutual funds in the US grew 1,600% over the following twenty years. In comparison, the total number of funds grew 600% in the previous forty years. There was a new game in town called the 401k plan, and all the investment companies were rushing to play. Why? There was a lot of money to be made.
Today there are nearly 10,000 mutual funds traded in the US, but there are less than 4,000 stocks. Remember my formal definition of a mutual fund - a bunch of stocks grouped together as a single investment? There are roughly two and a half times as many funds as there are stocks. How insane is that? If it is tough to pick winning stocks from a list of 4,000, how much tougher is it to pick a mix of winning funds from a list of 10,000?
So what does this mean for you?
Remember, the stock market was established so companies could raise money and grow, and mutual funds are products created by investment firms. People like you and me have the opportunity to be co-owners of publicly traded companies. The further you stray from that concept - i.e. investing in mutual funds or funds of funds, the further you separate yourself from the original intent of the stock market and the closer you get toward filling someone else’s pockets.
It’s important you understand what mutual funds are and why they were created in the first place. After learning more about them, you may feel better about your choice to invest in them, or you may want to explore other options, but at least you’re informed.