While stocks have certainly had phenomenal returns over the past two decades, they have also been volatile and risky at times. As I have stressed before, stock investing is not for the queasy. We will more than likely see bear markets again in the future.
I hope you realize by now that investing in stocks is not easy. It takes discipline, smarts, hard work and a long-term perspective. By hard work, I mean you must take the time to learn about stocks and spend significant time deciding which stocks to buy. For many, this process will be uninteresting and tedious. Furthermore, most people don’t have the time or discipline to invest in individual stocks.
If you want to have nothing to do with picking individual stocks, but still want to benefit from the stellar returns of the stock market over the past two decades, then a vehicle such as a mutual fund is probably right for you.
A mutual fund is a basket of stocks, sometimes thousands of them, that are bought and sold by a fund manager. When you buy a share in that mutual fund, you are essentially buying a miniscule ownership in many companies.
By spreading your investment among many companies, you reduce your risk of seeing your portfolio completely devalued from speculative or highly volatile holdings.
However, your mutual funds are probably not going to see much greater returns than any market index because of the amount of stocks owned. Moreover, many mutual fund managers don’t beat the market indexes.
Mutual funds also charge expenses that will eat away your annual returns. These expenses are stated as an expense ratio. The average expense ratio is about 1.5 percent. For example, an expense ratio of 1 percent on a $10,000 investment would mean that you pay $100 a year for the managing firm’s expenses. $100 might not seem like a lot, but over several years you could pay thousands of dollars, depending on how much you invest.
Don’t get me wrong – I think mutual funds are a great way for an investor to have exposure to the stock market. Fund managers like Fidelity’s Peter Lynch and Legg Mason’s Bill Miller have turned out big gains for their investors – most likely far more than an individual investor could have achieved by themselves.
I just wanted to point out some of their drawbacks to show you why they might not necessarily be the best stock investment, or the best place to park all of your retirement money.
If you are interested in mutual funds, firms like Fidelity, T Rowe Price and Vanguard are good choices for low-expense funds.
There are two other new investment vehicles for stocks that don’t encumber the investor with high expense ratios and dismal fund manager performance. In my opinion, both are good alternatives to mutual funds.
The first, index funds, have been around for a while. They, like mutual funds, invest in a basket of stocks that seek to track an index like the S&P 500, Dow, NASDAQ or Russell.
All index funds are not equal.Some funds track averages better than others, but overall you are betting on the stock market and the long term success of companies in the index, not on the stock-picking prowess of fund managers.
Index funds also have the extra incentive of having razor thin expense ratios, so you get to keep more of your portfolio assets and returns.
Another investment vehicle that has been around for a while, but has seen a greater proliferation over the last few years, is exchange traded funds (ETFs). They are similar to index funds in that they just seek to track an index.
However, they are unique in the ability to buy and sell them like stocks in your brokerage account throughout the day. They also trade at very low expense ratios.
I think mutual funds, index funds and ETFs are good places to invest for people who don’t have time to actively manage a stock portfolio.
However, you have to do your homework, learn about how funds work and research specific funds before you buy. All funds are not created equal, and there are a lot to choose from. For more information on these and other investment options, go to morningstar.com.