You don't have to have a lot of money to get started investing. You don't even have to buy stocks and bonds to be an investor. And you can reduce the risks associated with owning individual stocks and bonds. It almost sounds too good to be true, doesn't it? But a thing called mutual funds can do all that.
This is the third post in a series about the basics of investing, where we'll learn how mutual funds – especially certain types – can make investing easier, especially if you don't have a lot of money. This builds on what we learned in previous posts by following the experience of two investors, Aunt Jane and George: the basic characteristics of stocks and bonds, and the kinds of risk that bondholders and stockholders face.
To find all the posts in this series, click on "investing" under the list of categories on the right side of the screen.
~Karen
George has always heard that investors shouldn't put all their eggs in one basket. If he invests all his money to buy stock (or a partnership) in a single business such as his friend's company, Freddie's Finest Furniture, he figures all his eggs are in one basket. Maybe he should diversify. But how? Does diversification mean he has to buy stock in a whole bunch of different companies? How does he choose them? And later on, how does he decide when to sell or when to buy more? It sounds intimidating.
Aunt Jane is thinking the same thing. Even though she's less likely to lose all of her money with bonds (loans) than with stocks, maybe she should diversify, too.
Mutual funds provide diversification
Investing in mutual funds is an easy way to achieve diversification. Mutual funds pool the money of many different investors, each of whom owns a portion of the fund. The fund's value is determined by the value of the investments inside of it – the prices of the stocks, bonds, etc. that it holds. You buy shares of the mutual fund, and indirectly own shares of whatever is inside the fund. Almost all mutual funds are "open-ended" meaning that you can buy shares from them at any time, and sell shares back to the fund at any time. You don't have to find someone else to buy your shares.
Each mutual fund invests in a certain type of asset or range of assets. One might invest only in US large company stocks, others only in US government bonds or stocks of European companies, while yet another can own both US stocks and US bonds. Most mutual funds own stock in many different companies in different industries, although some mutual funds target a particular industry or sector such as banking/finance or automotive.
By owning a mutual fund instead of individual stocks, George will have diversification through that single investment. He has delegated the responsibility for picking and choosing the companies in which to invest.
Diversified mutual funds reduce risk
Diversification reduces business risk. One company or an entire industry might do badly, but because it only represents a portion of your investment, the impact is much less than if all your money were invested there.
As a result, it's less likely that George will lose most or all of his money, compared to having all his money invested in a single company like Freddie's Finest Furniture, or a single industry.
George will still face market risk, the risk that the entire stock market drops.
Index mutual funds usually beat the average actively-managed mutual fund
I often joke that with investing, being average is a good thing. What I mean is this: if your investments consistently do as well as the stock market as a whole, you will have done better than most "active" fund managers – the ones who purposely pick and choose which companies to buy or sell based on how well they think the companies will do in the future. I know, it's hard to get your head around the idea that being average is a good goal. But the research is clear; in most asset classes, the vast majority of active fund managers underperform the market. Being consistently average will probably produce better results.
What's the alternative? Index mutual funds shoot for average. They each follow a particular index, which tracks and measures the performance of entire asset classes, such as the entire US bond market, the entire US stock market or a portion of it such as small company stocks or large company stocks. The Standard & Poor's 500 is probably the most well-known index. It tracks the performance of large US companies. There are also indexes that track stocks of the developed countries and developing nations, and their bonds. The index mutual fund's goal is to replicate its index's performance, not beat it.
Even more simple: Target date retirement funds
Target date retirement funds are another way to simplify investing. Instead of choosing three or four (or more!) mutual funds to cover different asset classes and having to monitor whether one of them becomes too large a portion of your portfolio, you can own just one target date fund.
George should choose a fund based on the approximate time he'll retire, such as 2030, 2035, or 2040. As he approaches and passes that date, the fund will gradually shift its allocation between stocks, bonds, and cash to be appropriate for someone his age.
Most target date retirement funds are funds-of-funds, meaning they own shares of other mutual funds that represent the different asset classes. Most target date funds have actively-managed funds inside of them, but at least one company uses index funds.
Get started investing with a small amount of money
Mutual funds each have a minimum initial investment, usually $1000 or more.
If your employer has a 401(k) plan, you can get around those minimums for the funds in your plan. You can start with whatever amount you decide to have deducted from your paycheck. If you open an IRA account, you may be able to start with a lower initial investment if you agree to make additional, regular contributions.
There isn't a minimum to start investing in an exchange traded fund (ETF). These are similar to mutual funds, but you buy and sell them like stocks. That means you can buy just one share at a time. Depending on the ETF and which brokerage or mutual fund company you buy it through, you may pay a brokerage fee for each purchase, which could increase your investment costs especially if you make small, frequent purchases. On the other hand, the expense ratio - the annual cost of owning a fund - is often lower for ETFs than for mutual funds.
If you have put off signing up for your employer's retirement plan or setting up an IRA because you weren't comfortable making the choices required, perhaps the ideas in this post will help you move forward. And with the New Year just around the corner, it's a great time to get started on a new goal like investing or saving for retirement.