Aug 25, 2018
Three reasons stock funds are great for beginning investors
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Investors who are new to finance, or those who don’t have a lot of time to invest (pun intended) often find stock mutual funds to be good investments for them.
“An investment in knowledge pays the best interest.” — Ben Franklin
Stock (equity) mutual funds buy shares in companies. Some funds are actively managed, meaning that the fund has a staff that picks the companies, generally with some type of filtering process to find the companies they think will do well. Other funds are passive: they invest in a specific index or asset class and don’t try to pick stocks. These funds, also known as index funds, don’t have analysts choosing their investments, and so their fees tend to be significantly lower than a comparable active fund.
On either style, the fees are usually deducted from the return, so investors won’t pay out of pocket. For example, if the return of the fund was 6% (600 “basis points”) and the fee was 0.50% or 50 basis points (bps), the investor will be credited with 5.5% return.
Investors purchase shares of the mutual fund, so they have exposure to all the companies in the fund.
- Diversification
If your portfolio is composed of one stock and something happens to that stock, your entire portfolio will be wiped out. People who worked for Enron in the early 2000s left their retirement account entirely in Enron stock lost their life savings because they didn’t diversify their portfolios beyond the company.
Having different companies and different types of companies in the portfolio helps decrease or avoid this risk. If you had been invested in an index fund with 499 other companies in it, one stock with severe losses would have a small effect on the portfolio, but not destroy it completely.
In order to properly diversify, you likely need more than one fund. For example, an S&P 500 index fund invests only in large US companies, because that’s what the S&P measures. Smaller companies and foreign companies would spread out the risk more. Or, you could buy a global index fund that includes US and foreign companies and that would take care of it.
For more information on diversification, see the article here.
2. Staying sane in a volatile world
Investing is a long-term endeavor. Compounding works over years and decades, not days and months. But many beginning investors make the mistake of looking at their portfolios too often. (By contrast, I look at my retirement portfolio seriously once a year, since I am a couple of decades away from starting to need the money.)
Stock prices fluctuate fairly frequently.
A stock can go from positive to negative return in a few seconds, and finish the day significantly different, for better or worse, from where it was at the beginning.
Too many investors get nervous when the stock prices go down. We humans have a significant inborn bias toward loss aversion. Often, the decrease in price leads to a nervous investor selling right when they shouldn’t: at a loss. Investors can experience serious regret if they feel their stock picks aren’t doing well, which results in a lot of trading.
Buying and selling repeatedly is expensive, because there are fees for trades.
It’s much cheaper to invest in something and course-correct once in a while, after having given the investment a reasonable chance to perform. This reasonable chance is on the order of several years, not several months.
“Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.” — Seth Klarman
Purchasing mutual funds instead lessens the regret that comes with choosing the “wrong” stock. They reduce trading, whether the investor is beginning or not. It’s especially easy when using index funds, because you’re not making a choice to choose one money manager over another — you’re letting the market do its work.
3. Ease of purchase
Mutual funds are available at any brokerage or wealth-management firm. Discount brokers offer them, and most company retirement plans offer them as well. There are normally a number to choose from, and transactions are easy to perform online.
In stocks, you have to purchase a certain number of shares, which might make it difficult to figure out how many shares of a company you can afford to buy, particularly with the price changing every second. With mutual funds, you provide the dollar amount, so the number of shares are calculated for you using the closing price at the end of the day. This often results in partial shares, which you don’t get with stocks.
This makes setting up automatic contributions pretty simple. In a company retirement plan such as a 401(k) or 403(b), the employee can designate a % of salary or a dollar amount to be contributed every pay period. If funding an IRA or Roth IRA, the specified contribution amount can be deducted from a bank account and transferred to the retirement account automatically.
I highly recommend setting up automatic contributions to help save enough for retirement!
Summary
Stock mutual funds are a relatively frugal and easy way to invest in the stock market, while avoiding some of the pitfalls of investing in specific stocks.
If you’d like more information on quickly getting started with investing, check out the book.
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