Mutual funds are one of the brightest investment ideas ever invented.  Mutual funds allow many investors to pool their money.  This allows these investors to diversify their assets in a way that would not be possible on their own and to hire investment professionals to make the on-going investment decisions.  Over the years the mutual fund concept has grown.  Today there are over 8,000 available funds.  Funds exist for almost every conceivable investment concept you can imagine (and a lot of concepts ordinary investors can’t conceive of.)  Chances are strong that you should be using funds somewhere in your investment and savings strategy.

One of the daunting problems for would-be fund investors is the huge number and types of funds.  This article will not solve that problem for you.  It may help a little, however, by describing some broad categories of funds in a way you may not have thought of and offering ideas on how you can use them.

I will define three broad areas of funds: investment objective funds, sector funds, and index funds.

Investment Objective Funds: The major investor effort required is determining your financial goals and choosing among the many funds with appropriate objectives.

Many mutual funds are designed to achieve a certain investment objective.  A few examples include; high growth, long term growth, growth and income, tax-free income, safety.  All the investor has to do is figure out which funds meet his goals.

Investors that have neither the background nor interest in making multiple on-going investment decisions should use these funds.  As mentioned the most important thing the investor needs to do with respect to these funds is determine her investment objectives and tolerances for investment risk.  It is then fairly easy to find many well managed funds with investment objectives consistent with those objectives. 

Determining your personal investment objectives and tolerance for risk is the very minimum that every investor must do before making any kind of investment.  Even a child putting money in a piggy bank has concluded he wants to see the money pile up with no risk of losing it.  (Except for the risk of parents and older siblings making unauthorized emergency loans to themselves.)  As we get older the determination gets more complicated. Even if a person wants nothing to do with investment decision making she should thoughtfully consider goals and risk tolerances. No one else can do it for her. 

As basic as the task of determining risk tolerance is it is frequently glossed over, probably because it is difficult to determine.  It is common for on-line questionnaires and even financial planners to simply ask, “What is your risk tolerance?” Usually, the investor has no idea.  In September 2002 there was a Meridian article entitled “Risk”. Here I will simply say your risk tolerance is a function of three things:

·         Time horizon.  Longer horizon can assume more investment risk.

·         Financial resources.  Greater resources can assume greater investment risk.

·         Tolerance for investment volatility.  People that become anxious when their investments fluctuate in value should take less risk.

Once you have established your risk tolerance you can focus your research on funds that have investment objectives consistent with your tolerance.  You may want long-term growth.  There are many funds available.  You may want current income with growth as a secondary consideration.  Everything is available.

The advantage of investment object funds is that you can invest in a fund consistent with your objectives and forget about it.  The fund management company will manage the assets in an attempt to meet the fund’s stated objective.  If an investment in the fund becomes inappropriate they will replace it.  You do not need to worry about making such replacements.  Further, the fund will hold a number of securities.  Thus, you achieve an important level of diversification without needing to invest in numerous individual stocks and bonds.  As your investment assets increase you can further your diversification by investing in several funds.  When it comes time to review and change your investment objectives you can easily switch funds.

I must remind all of us that almost nothing in investing is certain.  The prospectuses of all mutual funds will describe the risks and uncertainties.  There is no guarantee that the fund you select will actually achieve the objective you hoped for.  However, the professionals that manage the fund stand a better chance of achieving the goals than the average layperson.

Sector Funds: The major investor effort required is to determine which sectors will perform best and make ongoing sector rotation decisions.

These funds are designed to reflect the investment fortunes of a particular economic sector.  Investors who have the interest and skill to make on-going investment judgements about various areas of the economy should consider them.

For example, an investor may have reason to believe the medical area will be a superior sector of the economy.  He may want to participate without having to go to the effort of doing a lot of research on individual companies.  This investor can buy a sector fund that will do the work for him.

These funds are particularly useful to the investor who is willing to follow the economy well enough to rotate from sector to sector.  Good investors understand that different sectors of the economy tend to perform better at varying times of an economic cycle.  For example, when interest rates are falling interest sensitive stocks like financial companies tend to outperform cyclical stocks like steel companies.  At another point in the economy an investor may see that consumer confidence is rising.  This usually leads to increased purchases of consumer durables.  This in turn favors manufacturers of automobiles and appliances.

Making these broad decisions may be something an interested but casual investor can do.  But following the hundreds of stocks within a particular sector may be difficult.  Further, the investor can easily rotate from sector to sector as she sees the world changing.  This is an excellent way to maximize investment profits. 

A word of caution if this sounds intriguing but you haven’t done it before.  You must be early.  Resist the temptation to plow into a sector that everybody already loves and is talking about.  Think of all the Internet sector funds.  Money cascaded into them right at the top in a speculative fever then imploded in a matter of months.

Sector funds are not restricted to neatly defined economic sectors.  You can buy Japanese funds if you think Japan is ready to take off, or gold funds if you believe gold is good, or even green funds if you think you should only invest in non-polluting companies.  Dream up something.  There is probably a fund out there that fits.

Index Funds: The major investor effort required is determing which index reflects your investment strategy.

Index funds are designed to mirror a particular stock or bond index.  Indexes themselves are designed to provide broad performance information about how the stock or bond markets or some part of those markets.  Some of the most famous indexes are the Dow Jones Industrial Averages, the Standard & Poors 500 Index and the NASDAQ Index.  I haven’t counted but it seems like there are as many indexes for measuring some segment of the financial markets, as there are mutual funds.  For example, did you know there is a Russell 2000 Growth Tobacco Free Index?

Many mutual funds are designed to perform exactly like the index.  Most of these funds are geared to the most famous indexes like the S&P 500.  However, there are many geared to sector indexes and other specialized indexes.

There are a number of advantages in index funds. 

First, they can be either investment object funds or sector funds.

Second, the fees paid by investors are generally substantially less than other funds.  In these funds you are not paying for the skill of a portfolio manager attempting to beat the market.  The securities in an index are a matter of public information and a computer can be programmed to do the buying and selling necessary to replicate the index.

Third, there are many people that believe professional portfolio managers can not beat their benchmark indexes over time.  There is some empirical evidence to support this cynicism.  Buying the index fund pretty much insures you will have the same returns as the index, less fees and transaction charges.

Mutual Funds are Easy to Buy

Mutual funds are sold widely.  You can buy them from many types of financial institutions including banks, insurance companies, brokerage houses and, of course, directly from the mutual fund companies themselves.  You can use them in 401k’s, IRA’s and in regular investment accounts. The large mutual fund organizations have products in all three of the categories I describe here.  If, with a little research, you know what you need then lean toward buying “no-load” funds.  These funds have no up-front or 12b-1 marketing costs embedded in them.  If you want professional help contact a financial planner.  Often the financial planner receives most or all of his compensation from the marketing “loads” that are included in many funds.

As part of your research go to the mutual fund company’s web-site.  All of them list their mutual fund products.  Generally, they are sorted or you can easily sort them by objective and style.  The site will include descriptions of the objectives, fees and past performance.  Avoid the trap of buying the fund that performed the best last year.  These often perform the worst next year.  This phenomenon is usually just normal market rotation and doesn’t necessarily mean there is anything fundamentally wrong with the fund.  Look for a solid long-term performance of the fund relative to its established goals. Before investing do obtain a prospectus and read it.

Funds are a Great Idea but You Still Can’t Take Them with You

Mutual funds really are one of the brightest investment ideas ever invented.  Normal people can participate and benefit from the miracle of capitalism.  You can put in as much or as little investment effort as you want.  If you simply want a fund that is designed to meet your investment objectives you can find them.  If you want to analyze the investment implications of everything from the economy, to politics to sun spots you can do it and find funds to implement your conclusions.  You can even spend your entire career studying mutual funds if you want too.  But please reserve time to study the scriptures too.  Even though mutual funds are a great idea you still can’t take them with you.