Over the last couple of weeks, I’ve written about the advantages of investing in individual stocks and some tools to make the process simpler and easier. However, most people don’t invest directly in individual stocks. After all, it’s more time consuming and is generally not available in the employer-sponsored plans like 401(k)s that people generally do the bulk of their investing in.
Instead, most people invest in stocks through mutual funds. The advantage is that they make it easy to invest in certain categories of stocks like large cap US growth stocks or foreign small cap value stocks by providing instant diversification within that asset class and professional management while still giving you control over your overall asset allocation. They’re also available in virtually every type of account
There are a few downsides though. One is that the responsibility is on you to make sure you’re properly diversified. If you’re not sure how to do that, take a risk questionnaire like ours and see the basic guidelines based on your risk tolerance and time frame or look at one of these model “lazy” portfolios designed by some of the top investment experts.
Second, mutual funds charge fees to manage your money and rack up costs every time they trade. Both of these expenses can significantly impact your returns. In fact, keeping these costs low has been shown to be the best indicator of how well a fund will do in the future, much better than looking at past performance.
How do you keep your costs low? If possible, follow Warren Buffett’s advice and stick with low cost index funds. They’ve been shown to consistently outperform more expensive actively managed funds. In fact, Buffett is currently winning a $1 million bet (for charity) that a simple S&P 500 index fund will beat a group of top hedge funds. If you don’t have index funds available in the asset class(es) you need, look for funds with the lowest expense ratio (fees) and turnover ratio (how often the fund trades) for that particular category.
Third, you lose some control over taxes, which you have to pay every time your fund sells a stock in a taxable account. Sticking to index funds is one way to reduce this tax burden since index funds don’t trade as often. Even better, consider ETFs, which are generally index funds that trade on an exchange and generate even less taxes. Finally, try to keep certain types of stocks like REITs and other high-dividend payers in tax-sheltered accounts as much as possible since you’ll have to pay taxes on those dividends in a taxable account.
Finally, the biggest downside of mutual funds is that they’re still subject to user error. A couple of common examples are moving money in and out of funds to chase performance or to try to time the market. I’m sure there have been a lot of smart people with very sophisticated equipment who have tried to figure out how to do that and none of them have been able to successfully. Even if you get lucky, that could only encourage you to make bigger bets in the future that probably won’t turn out as well.
Instead, you’ll want to stick to your asset allocation plan and re-balance ideally quarterly or at least once a year. This will force you to follow another piece of Buffett’s advice to be greedy when others are fearful and be fearful when others are greedy. Your employer’s plan may even have a feature to re-balance your investments for you automatically.
Diversify. Keep your costs low. Stick to your plan and re-balance. Investing doesn’t have to be complicated, especially using mutual funds.