What is a mutual fund?

For decades, mutual funds have been a part of the investing landscape. They are easy to use, are available in a wide range of investment options, and are generally accessible to everyone. Mutual funds offer a safety in numbers approach that benefits the investor in numerous ways by spreading risk, offering diversity, and for better or worse, a mutual fund manager to guide the process. Read the full article here.

Good news/Bad news

While we have all been, on occasion, asked to choose between the good news and the bad news, when it comes to your 401(k), both sides of the question mean something. Today, I'd like to look at some of the good news, bad news that has been coming out of the world of the 401(k).


Investments
Good news: People continue to contribute to their 401(k). A recent Investment Company Institute report found that only 2.4% of investors using this sort of plan did not contribute in 2010. This is considered a generally good statistic for two reasons: the resurgence of the company match may have prompted more people to begin to contribute more in 2010 than they did in 2009 (3.4% ceased contributing) and two, the stock market rewarded these folks for doing so. This means that account balances also increased.

Bad news: Those who did continue to invest actually pulled money from the equity side of the investment equation. The ICI was confused by the pattern, which typically dictates that when the stock market does well, investors tend to increase their holdings rather than withdraw. The shift they suggest may point to a lower risk tolerance which doesn't necessarily explain why there was an increase in international exposure.


Risk
Good news: There is a much clearer understanding of the risks involved in the investment world. Although there are still a sizable number of senior investors (those at least 65-years-old) who are willing to take above average risks with their portfolios, most recognize the danger in doing so.

Bad news: too many younger folks are unwilling to assume risk via equity investments. While 10% of the 65-year-olds reported they take on above average risk, their counterparts in the  35-to-49 age group admitted that they do as well. Defining above average risk is often difficult to do. Related to a balance of investments, with popular sentiment suggesting a gradual decrease in more volatile investments (equities) to more conservative ones (bonds, fixed income), this group may be making these adjustments too soon in their investment lives. If, as popular sentiment suggests that we will work longer, a 35-to-49 age group could possibly be leaving a certain amount of aggressiveness untapped. If you are thinking that you will work until 70[years-old and beyond, a 35-year old should invest in much the same way as 25 year-old would have just ten-years ago.


Better 401(k) choices
Good news: There has been over the last several years, an acknowledgement of sorts from the plan sponsor world that better choices for their participants is directly correlated to the types funds offered. Fees dominated the conversations held by plan sponsors and administrators as those that used their plans turned their focus on how much each investment was costing them. Plan costs eat away at potential returns. So many plans reduced the number of funds offered and with those reductions, the types of funds offered. The shift to a larger selection of index funds and target date funds may have helped create a better investment environment for those using the plans.

Bad news: As fees were lowered amongst the plan's offering, the plan itself became more expensive. This change in how the fees are levied make both the newly low-cost funds offered simply appear as if this were a bait and switch. Fee disclosure will only increase in the coming years as the Department of Labor looks to better reporting of these costs. The trouble is you may not where to look and may be able to little about these costs. You can sue over poor investment choices. But unless you actually leave the company you work for, the 401(k) you have is what you are stuck with.

Turnover

Good news: The turnover rate in the mutual funds offered by your company's 401(k) has dropped somewhat over the years. This is reflective in the choices. Index funds have near zero turnover, rebalancing only when the index shifts. Target date funds tend to shift in a similar way but don't offer the investor anyway of knowing how much is being turned over in the funds within the funds.

Bad news: While turnover is often equated with higher fees, a certain amount of this activity is generally considered acceptable if the rate of return is increased as a result. Most investors will shift their money into a fund based on the size. And the larger the fund, the more cumbersome investing becomes and because of that, the lower the turnover.


Target Date Funds
Good news: Target date funds have increased in plan usage from a scant $57 billion in 2000 to almost a trillion dollars invested in 2010. The good news here is limited to the success of the fund families marketing strategies and the required auto-enrollment of new hires. Add to that the financial debacle of 2007-2008 and numerous investors in 401(k)s simply saw the risk in these self-directed plans as too confusing. Turning to target date funds seemed on the surface to be the most logical conclusion for most.

Bad news: Target date funds still have some hurdles to jump through before they gain my seal of approval - no that they are necessarily currying my favor. They remain murky at best. Most target date funds, with the exclusion of those that comprise of index funds only, are a fund of funds. This suggests that a fund family, rather than close a poorly performing mutual fund, simply roll the fund into a target date fund. Because of this, there are still transparency issues. Add to that the suggested target date may not be your target, that no two target date funds are at the same point in investment holdings (risk) as a similarly dated cohort, that there is no fund manager who can offer conclusive evidence that this is the best method of rebalancing and lastly, that most users tend to set-it-and-forget-it.


Fees
Good news: As I mentioned, they have dropped over the last several years. But most investors still make assumptions that fall squarely into the "if it is an index fund, then it must cost less". This lower cost is mostly true and is  normally attributed to index funds, even though some smaller index funds that track the S&P 500 charge considerably more than their larger counterparts for the same investment. Even with that in mind, an investor can build not only a well-balanced portfolio using index funds alone, they will do so at a much lower cost than any other investment portfolio in their plan.

Bad news: Most target date funds act as if they can do what they do for less, they don't. Some target date funds have expenses and fees that are well north of 0.80%.


Participation
Good news: more folks are using their options across more age groups and accessibilities. Most mutual funds are held inside 401(k)s by twice compared to those held outside. Add to that the growing number of average to lower income households entering this market for the first time using this sort of investment.

Bad news: Education still has a long way to go. Trusting, finding or using an advisor is still the purview of the more affluent investor. The average balances in these plans increased but it suggests that was a result of an increase in the stock market value rather than an increase in participation or contributions.

Mutual Funds and SIFI

Are mutual funds a systemically important financial risk? It seems that so far, the answer is no. To explain what this dreaded SIFI label actually means, the NYU Stern School of Business has developed a risk indicator and alist of the top banks and CEOs capable of bringing the whole system down should their activities run into problems.

Senator Chris Dodd and Rep. Barney Frank, authors of the Dodd-Frank comprehensive financial reform law began identifying which institutions could be the most troublesome for the economy as a whole should they fail. It was one thing suggesting that all banks with $50 billion plus in assets be labeled as SIFI. But other institutions could also create risk and in the time since the creation of the reform law, other large entities have scrambled to get out of the way. Ideally, the right balance, not too many and not too few, something the Brookings Institute suggests as a Goldilocks problem, is what the law is aiming to create.

At a recent conference held in February, Doug Elliot asked the question: "So, if you’re going to define systemically important financial institutions you have to have some concept of what systemic risk is.  And you have to have some way of measuring it, at least in some subjective manner.  And are then setting a threshold to say where does something go from having too little systemic risk to worry about to enough that it should be treated separately here?" Mr. Elliot is well known as a former investment banker, former head and founder of COFFI, his own think tank, and a very prolific and insightful writer on financial reform issues with a book soon to be published titled "Uncle Sam in Pinstripes".

The biggest fear is what is known as a domino effect. Essentially, if a number of SIFI act in unison or a number of institutions engage in the same financial activities with an SIFI labeled entity, failure would knock one, then the next over, creating a systematic breakdown. But identifying who is at the greatest risk is a lot tougher than it sounds. Mr. Elliot points out that both irrational panic, such as a run on a bank creates, and rational panic, such as identifying the problem but making a wrongheaded assumption that whatever the problem is, it isn't really that bad, can both add to the systematic tumbling of one institution, and then another.

The recent crisis had a component about it that it turns out isn't all that unusual. In fact, most of the problems in the recent history all possess the same problems: assets that were overvalued and folks knew it and leverage that was chasing it, even if it knew it was overvalued. This embracing of risk is what causes systems to break and in some cases, have the potential for bringing the whole of the economy down with it.

Given their size, mutual funds were considered as well in the discussion (which can be found here). They are not directly leveraged nor are they intermediaries (such as insurers and re-insurers) or affiliates of larger financial institutions. In fact, mutual funds are generally referred to as pass-through entities. But some funds have worried regulators based on their size. But that size is not threatening if it isn't used as leverage.

The one exception Mr. Elliot pointed out was the money market mutual fund, an entity that many believe is, or should I say, was, as a safe as a bank - at least in the mind of the average investor. A buck, they thought was always a buck, until one moment during the financial crisis, when a MMF declared ti wasn't. Investors were told that there was risk. But with this sort of situation having never occurred, the risk was set aside for most investors.

While mutual funds may have escaped the scrutiny of those studying these financial risks, hedge funds, institutional investors (pensions) and some investment firms have not. Just because some funds fit some of the criteria, of which six are listed, doesn't mean that the Frank-Dodd regulations would necessarily miss this group altogether. They do have size but because of the number of funds available, they provide numerous substitutes for the services and products they provide investors.

There is an adequate degree of separation from other financial firms, an borrowing that they may do (leverage) is clearly stated by most funds in their charter. While many of the largest funds do face some liquidity risk if investors lose faith in the ability of the fund to perform, it usually occurs as a dribble of discontent rather than a one day sell-off. Mutual funds tend to keep a limited amount of cash on hand so a sell-off would be something that whole of the marketplace would be experiencing rather than just a handful of large funds (which all tend to be indexed to the market and not actively managed entities. In truth, funds that become too large, tend to lumber when attempting to move in either direction.

Those large index funds are passive. But some large bond funds may not be but their size keeps any sort of maturity mismatch from occurring. And the existing level of regulatory oversight provided by the SEC is seen as adequate to protect the overall system from any imminent problems.

Although MMF aren't necessarily problematic, as the Investment Company Institute, the lobby arm of the industry points out: "a liquidity backstop could provide reassurance to investors and thereby limit the risk that liquidity concerns in a single fund might spur in-creased redemptions".  There is a possibility that hedge funds might see this as an opportunity to roll what they do into into mutual funds. But the regulations provided by the SEC make this not as attractive.

It may be too soon for the mutual fund industry to breath a sigh of relief. While one or more of the 243 rules and 59 studies commissioned by Dodd-Frank may still find mutual funds in the crosshairs of the reform law, the industry believes that this will not happen.

The Overvalued Emerging Market

It is easy to be attracted to emerging market mutual funds in your portfolio. If you are investing through a 401(k), you have noticed in your last statement how well they have been doing. Your US equity funds have done well over the same quarter or even perhaps YTD. But the contrast with the mutual funds that might be available to you that invest in other countries might have caught your eye.

Return envy is still one of the primary weakness that investors have. They see a fund that has done well, in this case, almost the entire sector, and we jump, feet first without knowing whether there is a shallow bottom or not. In the world of emerging market mutual funds, that bottom might be closer than you realize.
Emerging market mutual funds have a great deal of headwind to navigate as they get those returns. And just like the days of yore - only two years ago or so - risk is the reason why. Those risks are numerous.



First is the money issue. No country can be considered a viable investment unless they have a good banking system. That statement could be the reason why many stateside investors have looked to other countries for their investment needs. But in truth, the US does have a better banking system than most countries abroad. In its defense, it is able to survive a serious economic blow, put together a plan to recover from it and, although it can be criticized for many of its moves of late, it will still survive even if it is has already shown much of its financial hand. The simplest way to do this si compare a developed and mostly mature system such as that of the US and those in that outperforming emerging market fund.


The second issue is politics. We might have what seems to be a chaotic and disagreeable political system. But because of that robustness, we can be assured that even though we don't know what taxes will be, the discourse on how much we pay will be discussed at length and resolved with compromise. In addition to how the government operates, it is still a business-centric governing body that even when it falters in doing what it considers right, it does what it considers best for the creation of jobs. And even if the US seems to be burdened with regulations, many of which are direct and legislative reactions to abuses, countries overseas have placed these sorts of restrictions before the fact. This keeps investments and innovation under the control and purview of whomever is in charge at the time.


The third issue is economic freedom. While we take capitalism for granted, it si not the case in the largest emerging markets. It is often difficult to comprehend that a country the size of China or India could be considered emerging. But the definition of emerging suggests that while growth seems to be on pace and often well-beyond that of the US and Europe, it is done without the transparency that we enjoy. If China has the ability to drop a trillion dollars in cash into its economy - something a developed country would need to borrow to do - this offers a glimpse of instability.


The fourth issue is risk. By risk I mean your ability to predict and project how much you might make and how much you might lose. Most of us don't do this sort of metric exercise prior to shifting our money from one place to another. We look at all of the basics: return, tenure, return, cost, return, risk, return. And then we buy.

Understanding the risk in an emerging market mutual fund is much harder because of the reasons I have already discussed. But risk comes in numerous forms and the one most likely to derail you is diversity. You may, through your target date funds, your index funds, and even your bond funds, all of which may bill themselves as domestic, may have placed some of your money in markets your are currently looking at with envious eyes. Diversity in a portfolio simply suggests that of there is trouble in one place, not all of the investments you own will be impacted the same. Some will fair better than others.


The fifth issue is investor impatience. Most emerging markets are not near maturity and therefore have a period of time to traverse before they become more reliable. Political unrest needs to be quelled, businesses need to feel as though their investments are safe from political unrest, money needs to be available to be borrowed and infrastructures are solid enough to make it all possible. This is difficult feat in developed and relatively stable economies. Imagine a country on less solid footing, unable to embrace different political outcomes and survive them more or less intact. Which means, the investor who is willing to pay the higher-than-normal fees for such funds, need to wait a much longer time to get back what they have invested in portfolio risk and cost.

This is not to say you shouldn't have emerging market funds. Ten to even twenty percent of a portfolio would be acceptable in most instances. Just be prepared for cloudy days and they will come and you will want to sell. But the developed world needs emerging countries to buy their goods. In that sense, the investment becomes symbiotic and over the long term, you will probably be pleased. But be warned.

(One final note: the exchange traded fund - ETF - market for emerging market investments has grown substantially. In this author's opinion, the risk of selling too frequently and chasing minute returns, as ETF investors are more likely to do,  poses just as much a risk as you would face if you simple held this investment for a longer period of time.)

Do You Know Where Your Muni Bond Fund is?

The vast majority of us who own municipal bonds, do so inside of a mutual fund.  But munis may be in a bot of trouble with more on the horizon.

We want to believe it simply isn’t so. Municipal bonds or munis, those hometown or home state, often tax exempt debt instruments which are favored among the retired, the soon-to-be retired or those looking for a conservative but well-paid return may be facing a little headwind. But truth be told, you should have noticed.

When you buy a municipal bond, you are essentially buying a project believed to be worthwhile for the city, county or state issuing the debt. They are rated in much the same way as a corporate bond is with a single exception worth noting. If a municipality issues a bond and has difficulty paying the coupon, they often simply raise the local tax rate to cover the shortfall. But like all sorts of funding, the increased tax revenue that would pay for the bond payment shortfall is also in short supply.

More on municipal bonds and risk here.

A Look Outside of the S&P 500

I have been on the offensive lately. Actively managed mutual funds, which if you have followed what was written here, are taking quite a lot of criticism from the index camp. Attempting to twist their argument in as many directions as possible, refining the debate to include survivor fund rates and using numbers that skew how actively managed funds compare to their inactively managed cohorts.

I argue that the benchmark is wrong. But to get a broader look at how different categories are doing, indexes do provide a good overview of performance. Some actually come very close to doing what actively managed funds attempt in those categories; others do not.

Here is a list of how these categories did through the end of August 31st. Keep in mind, the year-to-date performance of the S&P 500 is 18.2% to the plus side. Do you know where your risk is?

Latin America Stock/62.3%
Diversified Emerging Mkts/47.9%
Pacific/Asia ex-Japan Stk/45.7%
Technology/40.6%
Foreign Small/Mid Growth/34.7%
Bank Loan/33.6%
Foreign Small/Mid Value/33.2%
Europe Stock/32.3%
High Yield Bond/32.2%
Miscellaneous Sector/30.7%
Convertibles/28.7%
Communications/26.4%
Equity Precious Metals/26.4%
Diversified Pacific/Asia/25.7%
Global Real Estate/25.3%
Foreign Large Growth/25.0%
Equity Energy/24.6%
Mid-Cap Blend/24.3%
Mid-Cap Growth/23.9%
Emerging Markets Bond/23.8%
Natural Res/23.7%
Consumer Discretionary/23.4%
Foreign Large Value/22.6%
Financial/22.6%
World Stock/22.5%
High Yield Muni/22.2%
Foreign Large Blend/21.8%
Mid-Cap Value/21.6%
Small Growth/21.1%
Large Growth/21.1%
Target Date 2050+/20.7%
Target Date 2036-2040/19.9%
Target Date 2041-2045/19.5%
Small Value/19.4%
Small Blend/19.2%
Multisector Bond/19.2%
Target Date 2031-2035/19%
Target Date 2026-2030/18.7%
Target Date 2021-2025/18.2%
Large Blend/16.7%
World Allocation/16.5%
Target Date 2016-2020/16.1%
Moderate Allocation/15.6%
Target Date 2011-2015/15.5%
Target Date 2000-2010/15%
Muni Single State Long/14.9%
Large Value/14.5%
Consumer Staples/14.3%
Muni New York Long/14.1%
Muni New Jersey/13.9%
Conservative Allocation/13.8%
Muni National Long/13.5%
Retirement Income/13.3%
Muni California Long/13.1%
Real Estate/13%
Muni Massachusetts/13%
Muni Pennsylvania/12.9%
Industrials/12.6%
Health/12.4%
Muni Minnesota/12%
Japan Stock/11.9%
Long-Term Bond/11.9%
Intermediate-Term Bond/10.6%
World Bond/10.3%
Muni Ohio/9.8%
Muni Single State Interm/9%
Muni National Interm/8.7%
Muni New York Int/Sh/8.6%
Muni California Int/Sh/8.1%
Utilities/7.8%
Short-Term Bond/7.4%
Inflation-Protected Bond/6.9%
Long-Short/6.3%
Ultrashort Bond/6%
Muni Single State Short/4.7%
Muni National Short/4.3%
Intermediate Government/3.7%
Short Government/2.6%
Currency/-1.8%
Long Government/-11.3%
Bear Market/-27.2%

Mutual Funds Explained: Options in Your Retirement Plan

No doubt about it, your options in your retirement plan are about to change. There could be some questions about whether they need to or not. But rest assured, the effort is under way and many of these changes will not be seen as beneficial for the majority of us.

Cost cutting is one of the ways businesses had hoped to survive the economic downturn that is now a year old. Payroll has been chopped (including paychecks), inventories have been reduced (to accommodate the skeptical and mostly unwilling buyer at the retail level) and in many instances, the matching contribution that so many companies offered as an incentive has been greatly reduced or eliminated (and there is no expectation that this will change before 2011 0 if ever).

All of these moves have resulted in a stock market that has risen since the turn of the calendar year (the Dow is up 3,000 points since January). This vote of confidence by investors has encouraged companies to continue to trim any portion of their balance sheet that might be too costly. Keep in mind that these moves do not grow a business; they merely sustain it. Keeping it propped up in this way is a topic for another discussion. But the trend is alarming.

This cost-cutting mentality has found its way into your 401(k). In the coming months, expect the recent trend to continue. One way of doing this is to add funds with lower costs. According to survey conducted with 85 senior level executives (downloadable pdf), whose jobs require them to find every nickel and dime on the balance sheet, the change is just beginning.

Over half of those surveyed have or plan to make changes to their 401(k) offering by the end of 2009. Those changes will result in less equity funds available than there were just two years ago. What they plan no adding is more funds with longer durations, such as bond funds with long maturities.

This change has resulted in the firing (and in some cases the hiring) of different fund managers. This change has seen a net decrease in the equity side of their offerings in favor of fixed income. Domestic equity funds were reduced as a result of such moves by almost 20%.

These changes have also impacted the default investment side of the equation. Ninety-three percent of those surveyed now offer a default plan for those who have not signed up with 71% of those plans directing their employees to target-dated funds.

These execs also plan on implementing a stress test to these plans in an attempt to insure that certain predetermined funding requirements are met. This move does not necessarily offer additional disclosures for plan participants, ebven as Congress is looking into requiring such actions.

While taking fiduciary responsibility has been lax in the past, numerous companies are looking at adding some sort of monitoring system to protect their risk of liability for not doing so. According to Carl Hess, global director of investment consulting at Watson Wyatt “The uptick in activity could be a sign that many funds were caught off guard by the crisis and are now trying to mitigate their risk exposure."

Mutual Funds Explained: Prepping for the Third Quarter and Beyond

No market appreciates the beginning of a new quarter when it coincides with a holiday. No market enjoys bad economic news either. So, as earning season begins on Wall Street, a time of speculation, expectations and often dashed hopes and dreams, I want to take a moment and cover some of the behaviors that investors need to come to grips with.

Our sister blog has been reviewing some of the investor habits that are worth noting. You have just watched the recovery of many of your mutual funds, especially of you were not in index funds but allocated in growth both domestically and abroad.

Before You Buy: Why Investors Do What They Do

Loss Aversion begins the discussion with "Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made."

Investors are also guilty of narrow framing. "Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk."

Many of our beliefs about investing revolve around another bad habit: anchoring. Investors "may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring."

Mental accounting affects how we invest as well. "Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past."

Diversification is not what you think it is. "These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In the first part of 2008, billions of dollars were being invested in a market near it top. In the second half of 2008, billions were withdrawn. This is herding at its best and worst. "It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder."

And then there is regret. "One of the basic assumption in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret."

Nothing has impacted your investment style and direction and is in fact least suited to do so, than the media. "Has the hype in the media over the last several months had an effect on how your invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television."

And lastly, there is optimism, that feel good, I want to invest emotion that often gives us reason to engage in all of the previously mentioned investor behaviors. "In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior."

So before you get back into a market (that I hope you never left), take the time to examine the investor in the mirror.

Mutual Funds Explained: Measuring Mutual Fund Performance Using a Rolling Average

In a previous post on performance, I wondered if there was a way for investors to measure how well a mutual fund has done. Mutual fund managers often use comparison to less risky indexes as the benchmark for their own performance. This, we all know, enhances how the fund appears to have done. Right or wrong, I suggested that the ultimate guide to performance may lie in the investor; the person in the mirror who must assess their risk, their goals, and their expectations.

Richard Gates, portfolio manager for TFS Capital agrees. Interviewed recently at Forbes, he said: "I think the root of the problem is not really how returns are measured and presented. Rather, I think the basic problem is that investors just shouldn't be so fickle about short-term performance." And that accounting of performance is what we are faced with, almost daily.

The short-term also presents other problems. For instance, how can you tell whether a mutual fund manager simply has lost her/his/their touch even as the market declined for every fund? In other words, is bad really the fund manager's fault? Or is doing bad something entirely different?

It would be nice to throw 2008 out of the equation. But for the next five years, that year will show every fund as underperforming even as we forget about what happened in 2008, probably soon after we turn the calendar on 2010. The real test is how well they have done since March of this year (2009). But that would be looking to the short-term in the hope of finding some long-term potential. Is it possible?

Is it right to do so? Possibly not. If you are an investor, 2008 looked really bad. Yet, never have investors had such a clear understanding of what worst-case scenario looks like. Bear markets toughen investor hides across the board. Sure, many run for cover. But those that understand that bad can be turned into good, relish the opportunity to grab a once in a lifetime (or perhaps once in a five year cycle would be more like it) chance at finding out what worked and what didn't and even more importantly, why.

Keep in mind, even as funds fell, so did their comparable benchmarks. Were they still able to match, even beat those benchmarks in a down year? Did the fund family pursue a cost-cutting, fee stripping strategy to help boost your return, however meager? Did they look out of house for a different manager to run a fund that was really beaten down?

If your fund manager is still at the helm as I write this, look at their performance over the past ten years to get what is called a rolling average. Compare that number with the benchmark's rolling average over the same period. Then compare it to the peer group, using the same investment style as a comparison.

Then look at your risk factor again. The investor in the mirror will need to make some choices as well. And whatever you do, do not eliminate too much risk. Let your fund manager do what he can to mitigate out-sized risk as they struggle to regain your confidence and at the same time, increase their performance.

Mutual Funds vs. Stocks: Better, Cheaper, Easier?

Fellow blogger Jenny Decki at BeyondMom asks the following questions:

Why would I invest in a mutual fund?

If I choose five stocks (or 10 or 15) isn’t that (basically) the same thing as being in a mutual fund but without the fees?

I understand that a mutual fund has a manager that watches the stocks within the fund and makes changes as appropriate, but how is that different than day trading? (Other than the fact it’s someone else doing the day trading.)

Jen,

You raise some interesting questions: can you do what a mutual fund does and can you do it cheaply enough to make it worthwhile?

Mutual funds are still both cost effective, tax efficient, and in many cases, a far better investment than wading into the world of stock picking. Yes, mutual funds offer a fund manager(s), a level of research and discipline often not found in the individual investor, and the ability to diversify into a wide variety of stocks. Whereas the individual investor has far more flexibility to sell at moment's notice, some basic problems arise from the effort.

1. Which stocks to buy? While it depends on whom you listen to, the stock market has yet to retain any long-term stability. News, even reports that seem wholly irrelevant to the shares you might own, is still driving the investor to do things they would not normally do during a more stable and predictable market. True, no market offers itself to forecasts, and no stock is immune to industry trends, they can be and should offer some sort of confidence, a belief that the decision they have made is the right one long-term.

2. Which stocks offer long-term stability? Legendary investors always look for value. The average investor looks for gains. The two can be compatible but patience and time are what turns value into profits. Those looking for gains generally do not bring that sort of approach to the effort. Build a sample portfolio at any one of the financial portals and you can test this discipline before you commit real dollars. Keep in mind that these sample portfolios do not usually simulate trading charges or taxes.

3. Are stocks cheaper in the long run? Only in the long run. If you spend a fair amount of time looking at the tickers crawling across the bottom of broadcasts on CNBC for example, the wildly traded moves, the end of session strategies employed by many ETFs (exchange traded funds), and the instant reaction that many of these floor traders have to news (the ability to disseminate what is important right that minute to whatever position they may have taken) is very difficult for the average investor to control. Buying and selling all have costs (to you they are more expensive; to the institutional investor these costs are much lower) and depending on how much you have in your brokerage account, the advertised price many broker offer will be much higher.

4. Are stocks cheaper than mutual funds? Those same legendary investors offer the same legendary advice: fund your retirement, keep your financial house in order and only invest in individual stocks with money you do not need. Benjamin Graham, one of the most legendary of investors coined the term "Mad Money" to describe these accounts. He suggested that you should only put in money you do not need and never replenish those funds (if you win great; if you lose, lesson learned). Investing in stocks, for lack of a better analogy, is gambling. Ask yourself this: if you were at a casino and you had spent all of the cash in your pocket, would ask for a line of credit to continue?

That said, mutual funds still offer you the best way to keep your money working in the markets without taking outsized risks. Keep actively traded funds in your retirement account (the tax deferred opportunity is wasted on index funds in these types of accounts - keep them outside of your retirement account and pay the taxes on the gains and get the tax break on the losses). Be sure to take the time to build an adequate emergency account so you will never touch those retirement investments (these accounts are often referred to as savings - they are not), and if you still have money left over, wade into the ocean of stocks.

As Warren Buffet once said (as legendary an investor as you could quote):"price is what you pay; value is what you get."