Let’s begin with the bare bones, unvarnished, not for the squeamish truth. You have available to you the same information that professional investors and analysts use to make their decisions. That is a dismaying fact for many, for others a source of empowerment. You can say to yourself “If the pro’s don’t know anything more than me, what chance do I have of making some money for my retirement?,” or, you can say “if these jerks (no offense guys) don’t know anything secret, then what the hell is stopping me?”
First off, I’m not a pro, but I also haven’t lost my kid’s college fund yet, and actually have managed to finance a small vacation for myself now and again. Most professionals are as surprised as you by what happens to and in the market on any given day. That’s why it’s news when it drops. Not a single one can tell you with 100% accuracy if the S&P 500 Average will be up or down tomorrow: How many people predicted Enron? Or Stratton Oakmont? You need to realize that for analysts and financial planners, it really doesn’t matter, because whether or not you make any money on your investments, they get paid. Your adviser makes money either by charging for his or her advice—no matter how good or bad that advice might actually be—or by commission on your transactions. People who work at mutual funds don’t care either. Whether your assets shrink or grow, they get paid because their firms take fees, usually based on a percentage of the total assets managed. For them, it’s a zero sum game, that’s why mutual funds want to increase their share of invested assets–the more assets they have, the more money they make.
The Hands Off Mutual Fund
Mutual funds have been around since the beginning of the last century (around the 1920’s). These things have basically become the investment default for most Americans, usually because we can’t be bothered with the minutiae of business and finance. However, if you belong to the new leisure class or, if like me, you’re over educated and under stimulated, or you just hate other people doing things for you that you could better do yourself, I suggest that you begin by getting your furry little paws on Keys to Investing in Mutual Funds from the Barron’s Business Keys series. It’s easy reading, and you’ll learn a lot. An alternative book to get would be Peter Lynch’s classic Learn to Earn. Some others (yeah, I read a lot of this stuff) are Trend Following by Michael W. Covel, Getting Started in Swing Trading by Michael C. Thomsett, and if you’re really ambitious, The Wall Street MBA by Reuben Advani. Until you’ve read at least one of these (and preferably two or all of them), you should leave your IRA money (or any money you’ve invested, dreamt of investing, or haven’t even earned yet) wherever your financial advisor, your spouse, or your mom put it. At least it’s probably not in a bad place–except under the mattress. Under the mattress is bad.
Now, in simplest terms, a mutual fund invests a bunch of money provided by you (a shareholder) in a portfolio of securities that are chosen by the fund’s managers. Think of it this way: there’s you, Joe Shmoe, and Billy Bad Ass. The three of you have a million dollars between you. You hand over the money to me, Mr. Mutual Fund, and I decide what to invest in. You, Joe Shmoe, and Billy Bad Ass then pay me for my advice, and for the service of buying the securities. If I promised you a ‘no load’ mutual fund, I probably then nickel and dime you to death with silly charges that nonetheless add up for me because there are thousands upon thousands of people like you, Joe Shmoe, and Billy Bad Ass.
Diversify and Conquer
If you’re hands off, then you need Mr. Mutual Fund for two reasons: my knowledgeable selection of securities (remember what we said about knowing what the stock market will do?) and diversification. The first we’ve already covered. Diversification is probably the most important thing about selecting a mutual fund. Always remember that mutual funds, like any other investment vehicle just rise and fall with the general fluctuations in the market, so you need to protect your assets from catastrophic losses, and diversification does just that.
Diversification refers to a portfolio strategy that tries to reduce the chances you’ll lose your shirt by spreading out the money you’ve so graciously loaned the mutual fund company in a slew of investments including stocks, bonds, real estate, foreign markets, foreign currencies, and yada, yada, yada. It’s unlikely that all the segments of the market, all over the world, will all move in the same direction at the same time: say you own a house, right now, not so great. But, if you also own stocks, it’s a decent enough time (unless of course, the stock you own is like Enron). Whatever your house lost in value because of the ‘crisis’ in the housing market, you can either afford to lose because you’ve got stocks and bonds and other investments, or you didn’t feel the loss because the stocks you own may have gone up in value.
The idea behind diversification is to manage-not eliminate- the risk in a portfolio. Diversification allows for better, more consistent performance within a wider range of economic conditions. In other words, you can weather the storms better because all your eggs aren’t in one basket.
By the way, did you notice I said ‘manage.’ That’s because you don’t eliminate the risk if you don’t want to. “Huh?! Who wants risk?” Well, actually, you do. Here’s why: You know how a loser horse pays out more? Say you get ten to one odds on a bet. And here I’ll be pedantic a bit. That means that if you bet a dollar, and you win, I pay you ten. Why? Because it’s a sucker’s bet. That’s right. I want you to make the sucker’s bet, so I make the sucker’s bet more worthwhile for you. If the horse is a winner, you might not get ten to one odds. I might offer only five to one. (So, bet a dollar, and win, and you get five). OK. Pedantry over. The bottom line is this: if a stock is a sure thing (so, like, the price doesn’t gyrate all over the place), it will probably pay off less–because the price is stable, you end up earning or losing less money–the value though, is high–no matter how much you actually own. Sometimes you’ll hear these kinds of stocks referred to as ‘value’, or even ‘blue chip’ stocks.
The flip side is this: you actually want some risk if you can financially handle it: If you’re young, and far away from retirement you have more time to make back anything you might lose (just stay away from buying on margin, trust me on this one). The same if you’re single or child-less, you won’t be gambling away your kid’s braces or college tuition.
In any event, what you really need to do before you helm your own investments is to familiarize yourself with the details of the industry. You need to know what alpha and beta coefficients are, what yield, distribution, load, and volatility are. So, do your homework, and gather the information from an independent source–not the people you’re giving your money to. You can only evaluate an offering after you know what’s going on. A visit to the business section of your local library or bookstore will give you more information than you can ever dig through. Just try to avoid the hype.