Wednesday, May 27, 2009

Mutual Funds for the Utterly Confused: Blind Ambition

Sir Isaac Newton once said after a failed investment: “I can calculate the movement of the stars, but not the madness of men.” Do mutual funds change this madness into profits for the average investor? Had Newton invested in a fund instead of chasing an individual investment (like the one he purchased in the South Sea Company) would his money have been safer?

To answer these questions, it is important to understand some of the basics of what a mutual fund is and why it works for those who seek a longer range opportunity and lack the financial savvy to speculate (gamble is actually a better word).

First off, a mutual funds gathers like minded investors to a strategy that employs a manager, a team of investment managers and sometimes even a computer to look at stocks and bonds that fit the goals of its investors. This sounds simple but the "madness of men [and women]" can often play a much larger role in whether this goal is achieved. Mutual fund investors are looking for three basic properties: achievable gains, avoidable losses and control of that mental maniac that wants us to sell on the way down and buy on the way up.

Because funds are populated by the human factor, this madness is not often easy for the fund to control. No (actively managed) fund begins its existence with the goal of losing money. They gather information about investments, take positions in as little as twenty companies and as many as a thousand (often more with index funds, but that is another story) and allow the market to do whatever it may.

Does this mean that you relinquish some control over the day-to-day fluctuations of the market? Yes. And if that is the case, how should you react when the market turns ugly?

The stock market offers the opportunity to gain on the belief that the investment will perform better than it is at the point of purchase. When you buy a stock individually, this gain is realized in plain numbers. Conversely, any losses are also realized in plain numbers as well. In a mutual fund, because there is a huge number of shares in a large number of companies, a gain is diluted (just like any loss).

Unfortunately, mutual fund investors do not always embrace this idea of diversity. They often see the fund's failures as much more individual and its gains as much more muted. If the market surges, and it will, the fund is usually moving in a slower lane, getting there eventually but traveling at a more measured pace. If the market stumbles, and it will and has, investors are reluctant to embrace the possibilities that their investment, because it is diverse by nature, will protect them better than had they invested individually.

The comparisons with broader markets, such an index that tracks 500 of the largest companies, is not well placed. The fund managers have made decision to purchase only a portion of those companies and comparing their efforts against such a broad market is unfair. Yet it is done and often. How your fund performed against an index fund, how much you paid for the services of the fund manager and lastly, how well the fund has sold its philosophy all play a role in how you might react.

Funds have been positioned inside the our retirement plans for a good reason. 401(K) plans offer us the opportunity to invest evenly and consistently over time. This removes the buy on the way up and the sell on the way down problem that plagues individual investor psyche. The approach is called by several names: defined contribution is often used by perhaps more aptly, it is dollar cost averaging.

Once you determine how much of your paycheck will be contributed to this plan pre-tax, you have employed dollar cost averaging. This method uses a fixed dollar amount to purchase shares. Sometimes, when the market is on the rise, you buy fewer shares; when the market is on the way down, you are able to purchase more.

Sounds counterintuitive but it is exactly this method of buying that removes that mental maniac. Had you remained in the fund of your choice when the market was on the way down, made no moves to stop or limit your defined contribution, you will have benefited over the long-term.

But what if you panicked and sold those actively managed fund, opting for something like a target-dated fund, one that readjusts its investment goals over time to account for your age? Did you make the right move? Not necessarily. If you had picked one of these types of funds for the safety it offered, the hands off approach to investing, you would have done well to choose a fund whose target was twenty-years beyond the year you picked.

(Just a reminder about index funds: You will be tempted to use these funds if you know little about the way funds work, But don't. These are tax efficient and belong outside your retirement plan.)

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