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A Better Alternative to Mutual Funds – Wisdom Wednesdays #9

There are many advantages to owning a mutual fund, and so many people do. The beauty of owning a mutual fund is you are owning a whole portfolio of stocks instead of just one. By diversifying your investment, you are lowering your risk. I believe that everyone should practice diversification, because you don’t want all your eggs in one basket. Companies are more risky than most people may realize, but a portfolio of 5 stocks or more helps to reduce this risk. A mutual fund usually has many more holdings than just 5, and so the downside risk is decreased even more. However, there are some downfalls to mutual funds, which I will talk about in this post.

mutual funds

First off, mutuals funds aren’t as successful as we all seem to think. The professionals actually underperform the S&P average in most cases. Here’s a shocking stat: 75% of balanced 1 star mutual funds in 2005 no longer existed 5 years later. Want another one? The S&P Composite fund, which is an index fund, beat 89% of actively managed mutual funds in 2012. Stats like this aren’t hard to find and consistently reinforce the fact that mutual fund managers aren’t any better than anyone else. In fact, they’re actually worse in most cases and there’s several reasons why.

Mutual Funds Look at the Short Term

Mutual fund managers are often concerned with the short term instead of the long term. This industry is merciless, just look to their actions to see how. If a fund manager is underperforming, he’s fired. Look at all the mutual fund prospectuses and you’ll see 1 year return percentages. You think the mutual fund companies aren’t doing everything in their power to maximize these percentages? The stock market goes in and out of fashions and seasons. One year a growth strategy may be the best, the next year it may be a value strategy. Truth is, prices fluctuate all the time, and a successful strategy is consistent and long term. A successful strategy rides out the lows as much as it rides out the highs, because the focus is a long term return. Bad investors are jumping in and out of the market, trying to time it and capitalize on it. These investors are trying to play God, and are blinded from reality. The most successful investors don’t have a secret, guys like Warren Buffett openly share that their success comes from patience and basic principles.

Ok enough ranting, so why do we care? Well like I said before, a strategy that is constantly changing and bailing out at the worst times is going to be extremely unsuccessful. Everyone says not to sell low, but in fact many are doing the opposite because they are changing strategies so often. Or like in this mutual fund case, a manager has had a few underperforming years and gets the boot. The fund brings in a new manager with a new methodology, and all the holdings from the first manager get sold at the absolute worst times. Flash forward a couple of years and those same stocks that were sold at such a low price probably have rebounded while the hot stocks the new manager picked have fizzled out like all trendy stocks do. Throughout the whole time, the only person really bothered by all of this are the mutual fund shareholders.

Also, with mutual funds the share price can quickly drop out of your control. Of course all investments can drop out in a quick period of time, but mutual funds can sometimes see the worst of this. If a fund is underperforming, not only are their holdings in a bad condition but also the amount of people pouring money into the fund. Where do you think most people go when a mutual fund does bad? The average investor will probably take their money somewhere else to get better returns, which will in turn hurt the share price and hurt you if you are a shareholder. Again, these investors will sell low at the worst time, and it will become contagious and encourage more selling and more outflows from the mutual fund. As you can see, it’s the vigorous cycle of life in the emotional world of the stock and mutual fund market.

Mutual Funds and the Wall Street Life

Another thing to consider about the mutual fund managers is how involved they are with the stock market. Think about it, most of these guys are in the pits of Wall Street, New York , and the stock exchange. Their whole lives revolve around these crazy green and red ticker symbols that flash in the quickness of a split second. These guys eat, drink, live, and breathe the stock market, and that isn’t a good thing. The fund managers will often get caught up in the craze as much as everyone else does. They will invest in what’s trendy. They will ignore basic valuations, because they “know better.” Some mutual fund managers will disregard the history of the stock market only to be burned by the same lessons of managers who came before them.

One of the most popular traits of the “Oracle of Omaha”, Warren Buffett, was that he is so disconnected from the stock market. He doesn’t panic when the whole city of New York falls into a panic, and he doesn’t get swept up into the emotions. This is a guy who has a boring investing strategy; it’s nothing new and nothing flashy, but it is effective over a long period of time. Some of the best investors are those who can turn off the blaring T.V., disconnect themselves from the chaos from the world, and remember that everything will be o.k. in the end. The investors who leave emotions out of it, and look at the numbers as cold hard facts. I pride myself in disconnecting from Wall Street and the stock market, because it makes me a prudent investor. There are some mutual fund managers who are good at doing this, but they are few and far between. Do you want to wade through to find this guy, against all statistics, or would you rather not take the chance? Read on to find out more reasons why mutual funds should be avoided and what the better alternative is.

Think of this. Mutual fund managers don’t lose their life savings if the fund goes under. Just as the greedy CEOs who pillage from a company and then leave as the stock crashes to the ground, these guys don’t get hurt from bad performance. Who does? The shareholders. You. In an industry where above average returns bring hefty bonuses and career advancement, these fund managers take above average risk with your money. The consequences of bad decisions doesn’t directly affect them as it does you and me. Consider this logic, which I heard from word of mouth and has been proven in research. The fact is that the further away your money is from you, the easier the pain of losing it. Let me give you an example of this.

mutual funds 1

For one, it’s much harder to pay for a lunch with cash than it is with the swipe of a credit card. The pain is less with plastic. If you take it a step further, such as a gift card, the pain is even lower. The money on the gift card doesn’t seem to hurt as much as cash from my pocket, yet the net result is the same. This is the exact phenomenon with the mutual funds. The money travels from you, the investor, to the company and the manager, who doesn’t see the hard earned money like you do. To him, it’s just numbers on a computer screen and an opportunity to hit rich and become famous like Peter Lynch. The fund manager is disconnected from your money and is thinking, “Hell, if I could catch a hot streak like Peter Lynch did, then I could write my own book about it and sip margaritas on the beach for the rest of my life.” He’s also thinking, “no pain, no gain. No one has ever become great without taking risk.” End result of the story is a bucket of tears for the investors who were too lazy to learn about how to manage their own portfolio.

Mutual Funds are Expensive!

There’s another huge factor to why mutual funds are inferior. They are expensive. Many funds charge you front end and back end loads and fees. To the uninitiated, that means that you are paying a percentage of your investment to pay for the mutual fund managers and companies. Many mutual funds charge 5% or more on average, and this little bit can eat up your returns in a big way. Example. Let’s say you are investing $8,000 a year in mutuals, through your 401k or whatever. And let’s say you picked a mutual fund that charges a 5% fee, to keep it simple. So, you are losing $400 a year in fees to the mutual fund of your choice. Over a long period of time, the amount of money multiplies to significant numbers. In 20 years, you’ve lost a year of savings: $8,000. If a 23 year old started investing $8,000 a year in retirement in a 5% mutual fund, when that investor retired at 65, he or she would’ve paid $16,800 in FEES to mutual funds. What if that $400 was invested and earned an average of 10% return? Just from fees, the investor is missing out on what could’ve been $258,442.33!!

So let’s recap shall we? You are paying your hard earned money to let uninvolved and greedy fund managers likely underperform the market. If the loss from fees wasn’t enough to deter you, wait around for another bear market, where the panic selling will drop your life savings like a rock. Although there’s no magical pill to protect from market crashes and loss in portfolio value, the negative effects can be substantially suppressed. I’d like to introduce a low cost, low risk alternative into the mix: Index Funds.

Introducing..Index Funds

You may often hear me compare results to the S&P 500 index, and many other stock pickers do the same. In essence, an index fund buys all the stocks in a certain index and holds them throughout the year. An index fund is great because it picks a consistent strategy and sticks to it. The fund won’t incur excessive trading costs by too much buying or selling, and a fund doesn’t buy on emotions. You don’t have to worry about an index fund going under, because as long as that index is alive then so is the fund. I’m confident that no matter what dramatic stock tragedy occurs, the S&P 500 will continue to exist. And if it doesn’t, then we have much bigger problems than wondering about our investment accounts.

An index fund is beautiful because it is the cheapest option as well. For around a 1% fee (some are much lower than this), which all mutual funds charge in addition to the 5% for management, an index fund will simply give you the broadest portfolio at the lowest cost. There’s so many different index funds you can invest in. They have small cap funds, Russell 2000 and DJIA funds, NASDAQ and S&P 500 funds, and many more.

While the returns may just be “average”, in fact most mutual funds are performing below average. So by having average returns, you are actually beating most others investing in the market. What’s great is that you are greatly reducing risk, which maximizes the amount of your investment that gets compounded for even greater future wealth.

What you do with your money is your own responsibility, and I hope this article has helped you learn about the perils of mutual funds. While I’m not a financial planner and I can’t tell you what to do, I can tell you how I personally invest in the future, and you can decide for yourself what is best for you.

I take my 401k and invest it all in index funds. I look for the lowest fees, and balance between a bond index fund and a bond stock fund. The bond fund gives even better diversification for your portfolio and is crucial for even younger investors, in my opinion. The income from the bond funds can compound and grow alongside the capital appreciation from my stocks.

So, the majority of my future is in index funds. With non retirement investment accounts and IRAs, I implement my Value Trap Indicator stock strategy to pick my stocks. As you can see, I have a healthy balance of risk that’s just right for me. What is right for you may be way different than what’s right for me, and what’s right for my neighbor. It’s important to understand how much risk you are personally willing to take, which strategies you are implementing, and the education and reasoning behind it. Once you’ve taken the time to make these decisions for yourself, then implement them and stand by them. After all, you will be the only person who has to live with the consequences. Do yourself a favor and don’t blindly put all of your hard earned life savings in the trust of the local mutual fund manager. [Tweet This]

**All Rights Reserved. Investing for Beginners 2013**
**A Better Alternative to Mutual Funds – Wisdom Wednesdays #9**
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