My last post HERE talked about the pitfalls of individual stock picking from my personal experience of investing in what I believed were winning stocks based on my dear friend Carl's suggestions. It wasn't that the stocks were bad picks, but I lacked the experience to be involved in such a risky game. I sat on the sidelines for years in between each stock market attempt, and wasted valuable time because I simply didn't know how to build a portfolio with diversified risk. I'd heard of Mutual Funds before but wasn't really focused on building wealth and only thought about making big gains by investing in individual stocks. Now that I'm focused on securing a future nest egg, I did some research on Mutual Funds and other investment options and here's what I learned:
A Mutual Fund is an investment vehicle that pools your money together with other investors to purchases securities like stocks and bonds. Mutual funds are a easy and cost-effective way for individuals who don't have a lot of money to invest and own a piece of the market. Investing in a mutual fund doesn't mean you own actual shares of the particular stocks, rather you own shares of the specific fund itself. Perhaps the greatest benefit of mutual funds is the diversification is provides, allowing investors to spread their risk. Rather than my previous experience of investing in individual stocks which is synonymous with the old adage of "having your eggs in one basket", mutual fund investments provide exposure to hundreds of stocks. If you're currently invested in a 401K or IRA, then chances are most of your assets are in mutual funds.
Mutual Funds are actively managed by a portfolio manager(s) and a team of analysts who together seek to pick investments that will ultimately outperform its benchmark (S&P 500). Their ultimate goal is to maximize your return. The fund charges a fee, referred to as the expense ratio, and is deducted from the funds total assets to pay salaries for the portfolio managers and analysts as well as other overhead costs involved with managing the fund. The expense ratio is charged against each individual investor's account. Average mutual fund expense ratios hovers around 1%. That means for every $1,000 you invest the fund will charge $10. Fees this high start to really chip away at your returns over time. What if you don't want to incur such high fees but want the benefit of diversification? That's where Index Funds come in.
John Bogle is known as the father of Index Funds, having introduced the first fund in 1970, and later became the founder of The Vanguard Group in 1975. Index funds are still mutual funds in that assets of many investors are pooled to purchase stocks, bonds and other securities. The main DIFFERENCE is that an Index fund doesn't pay a portfolio manager or a team of analysts. Because index funds cut out the middlemen you incur a much smaller expense ratio (as low as .03%) for management of the fund. Index funds seek to track and mirror the performance of a market index like the Standard & Poor 500 (S&P 500) or the Russell 3000. Like the name suggests, the S&P is comprised of the 500 largest publicly traded companies in the US and similarly the Russell 3000 is a combination of the 3,000 largest publicly traded companies. Buying shares of an index fund that tracks either one of those indexes, will give you the growth in aggregate of all the companies represented in the fund.
Index fund investing is often referred to as passive investing because it's essentially a "set it and forget it" strategy. It's also an excellent long term wealth building strategy that provides broad diversification (depending on the index the fund tracks) that is aimed at maximizing your returns over time. Passive investing is all about a slow steady pace to creating wealth rather than aiming to make it big with one quick bet on a stock. It's synonymous with the "buy and hold" strategy surrounded by the idea that you'll make more positive gains over a longer period of time
If you feel you're ready to get on the road to building wealth, consider passive investing with Index funds. You can check out Vanguard, Fidelity, Charles Schwab and Blackrock for their low cost, no load mutual funds. (Load refers to transaction costs incurred to buy and sell shares in a fund). Always double check expense ratios before making a decision. It's not unusual to come across 2 index funds that track the same index but the kicker could be in the expense ratios. I recently did a over haul of fund selections in my 401k and I realized that I blindly followed the recommendations of an adviser and I was invested in funds with fees .46% - 1.15%. After revisiting my allocations, I switched to funds that range in fees from .05%-.09% that will ultimately help me meet my investment goals without swiping some of my cash in fees. Paying close attention to fees can save you hundreds of thousands of dollars over the life of your investments. When assessing what funds to invest in, it's important to look at their 10 year performance but equally important to note that a fund's past performance is not an indicator of future performance. If you follow a long term investment strategy, the goal is to experience the positive gains over a period of time. If you review the investment options in your company's 401K, chances are 75% of the offerings are mutual funds.
Bonds are a form of debt like an IOU except the bond purchaser acts like the bank. Entities like corporations, cities and governments issue bonds and promise to pay it back with interest payments, generating a regular stream of income. Local governments may issue bonds to build bridges, tunnels while the federal government sell bonds to finance their debt.
Most financial advisers would recommend allocating a portion of your portfolio to bonds. Like stocks, you have the option of buying individual bonds or buy a bond mutual fund. For the average person, a bond fund would be the easiest option. Bond mutual funds are just like stock mutual funds where funds are pooled with other investors and an investment professional invests the money according to the investment goals of the fund. Similar to a stock mutual fund, a bond fund offers excellent diversification since there are hundreds or even thousands of individuals bonds included in the fund. Investing in bond funds is known to reduce the volatility in your portfolio that's associated with stock funds, and can produce the income for your portfolio unlike stock funds. Your risk tolerance will help determine what percent of your portfolio should be allocated to bonds.
If you've ever had an interest in investing in estate but didn't have the capital to directly buy properties, you can actually add REIT's (Real Estate Investment Trust) to your portfolio. A REIT is a company that finances or owns income producing real estate. Similar to mutual funds, REITs allow investors to have ownership in real estate ventures without having to actually go out and buy property directly. REITs pay out a stream of income produced from the properties with high yield dividend payouts (minimum of 90% by law) to shareholders, making this type of investment incredibly attractive. Dividends can be reinvested which makes the power of compounding even more robust. There are 2 types of REITS: Equity REITs and Mortgage REITs. Equity REITs produce income from collection of rent and sale from properties. Mortgage REITs invest in mortgages from commercial and residential properties. REITs provide diverse exposure to real estate ventures including hospitals, apartment buildings, shopping malls, office buildings, hotels and warehouses. Before adding REITs to your portfolio, do your research to ensure it's the right fit for your investment goals and needs. Like any investment, there are risks to be considered.
Now that I've covered the basic investment options for the average investor, I'll highlight some of important factors worth considering before actually making a decision to invest in my next post.
Do you have any experience investing in mutual funds? If not, are you interested in starting your personal journey to building wealth? Leave me a comment below.