Mutual Funds and You: Not Always an Easy Relationship

Even if there wasn’t so much emphasis on the Baby Boomers with the threat that they will upset the whole of the investment apple cart by suddenly taking everything they have accumulated for retirement and flee the markets, mutual funds would still be what they are. In fact, they will always be what you believe they they are.

So what is the attraction? Convenience plays a huge role in why we continue to use this investment. These funds still play a major role in our retirement plans because of access via our 401(k) plans and Individual Retirement Accounts (IRA). The mainstay of these plans give the average investor, the one who knows they need the markets but are still unsure about the concept of investing, the potential of growing their retirement contributions.

Acting as a collective, mutual funds give these investors broad access to investments they would otherwise not have been able to build on their own. The confusion begins with which mutual fund suits our needs.

In almost every 401(k) plan, even the ones deemed as not so good, the investor has access to index funds (tracking broad markets), target date funds (which target a retirement age or goal and invest using an aggressive to conservative approach) and actively managed mutual funds (those that employ a fund manager to find investments that seek to best the indexes or benchmarks and provide better growth). In a growing number of 401(k) plans, access to ETFs (exchange traded funds that trade like a stock but are essentially index funds) and stocks (individual equity investments) have allowed investors to pursue different investment strategies based on their own assessment of risk.

The ability to use these plans to allocate money towards future retirement goals on a pre-tax basis simply means that this investment will not go away anytime soon. The mutual fund market is considered mature by most standards. It has adjusted to investor concerns about fees (index funds and ETFs offer the lowest costs to investors but are often seen as a slower, or better, a vehicle with more steady growth), the ability to serve those retirement goals by creating built in diversity, and increased transparency. In doing so, they have recognized the threat that index funds and ETFs can do much of the same without the cost.

Behavioral finance, a two decade old study of why we do what we do, has increased our own awareness of risk. This academic and economic examination of us has uncovered numerous biases, the embracing of fallacies and of course or tendency to harbor illusions. This look at the investor mind hasn’t changed what we do all that much. In part because looking at ourselves in the mirror, identifying why we still follow the herd, still have loss aversions, understanding why we still think the past is some sort of indication of the future and continue to delude ourselves with what our concept of reality is rather than what it actually is (think of a mime), is not as easy as they portray it to be.

In other words we sell too late, buy too late, fail to understand that we believe what we see and hear, and attempt to translate those feelings into investment actions. Seasoned investors have a better grip on this inner investor; new investors bring most if not all of the problems investors want to avoid to every action they make.

Mutual funds offer a comfort zone of sorts. Even as we seek to embrace the simplest fallacy: that mutual fund managers know what they are doing because they are in charge of hundreds of millions of dollars. Mutual funds offer us a set-it-and-forget opportunity to participate in the activity of investing without bringing vast storehouses of knowledge about the markets or even ourselves to the experience.

But do they produce as promised? Not always and not always enough of what we expect. Our anticipation of future growth – often based on what has happened – tends to be the first mistake we make. We look at the past performance, the stars a rating agency such as Morningstar might give a fund, the tenure of the fund manager, the turnover (how many times in a given year the fund trades its portfolio; the higher the turnover the higher the costs) and the fees against those returns and make decisions. And then we hope.

Should hope even enter into the equation? It does because of who we are. We have no idea what inflation will offer in the years ahead. Taxes will increase as Social Security benefits may decrease. Which leaves us with two options: invest more and hope for the best. This means that we are using a current self-sacrifice as the template for future returns. I have suggested this on numerous occassions: if you want the “current” lifestyle you lead to be the lifestyle you have in retirement you can either increase your contributions significantly (which impacts how much you have to live on now) or expect to live on less.

So how do we invest using mutual funds? The quick and easy answer is use index funds, spread these investments out across as many varied sectors as your 401(k) offers and increase you contributions.

But you will still look at actively managed mutual funds with a wanton eye. You can buy these as well but do so with great care not to cross-invest. In other words, owning an S&P 500 fund and a large-cap growth fund would give you the same category of investments and the same underlying investments. You might look to making your small cap and mid-cap investments in actively managed funds, where managers tend to be more nimble in volatile markets.

Yet, as in many things in life, there is a bottom line. In mutual funds, it involves education. You should learn what your plan offers and why. You should understand how long you have to invest and for what goals (even if they are far-off in the future and can’t be quantified let alone verbalized). And lastly, that lackluster contributions will most certainly provide you with lackluster retirement benefits. Mutual funds may be what you believe they are but not knowing can cost you.