This article was last updated on June 22
The title of this post was based on a question I recently received from a reader – Ben – who was new to equity investing and wanted to get some basic advice on investing in the stock market. He has about $5,000 to kick start his portfolio and wanted a simple, low-cost way to invest about $250 on a regular basis. He’s also a small business owner with a very busy day job meaning he has little time to follow the stock market. Finally he wants to build a low risk portfolio which provides some sort of regular payments (dividends).
Based on his criteria, I told Ben his best approach was to invest via Mutual (managed) or Exchange Traded Funds (ETFs), rather than directly with stocks. With his limited experience and time during the day to follow the market, individual stock investing was not a good idea. While I prefer ETFs for direct investing, Ben’s criteria for regular investing led me to recommend low cost mutual funds as a better investment vehicle for him because of the lower management overhead and ongoing transaction costs. Investing in ETFs is like investing in stocks and normally purchased in the same manner – meaning you pay transactions costs whenever you buy or sell an ETF. Mutual funds on the other hand normally allow free regular contributions as long as a certain initial and ongoing balance is maintained.
But before Ben started investing, I told him to keep the following 3 key principles in mind
1. The Right Research: This is often overlooked when it comes to investing via mutual funds. People think that if they go with popular options offered by one of the big mutual fund managers out there like Fidelity or T. Rowe Price then they won’t have to do anymore research. Unfortunately this approach will most likely result in mediocre results over time. The mutual fund industry is highly competitive and customers are fiercely fought for, meaning that companies will market their fund offerings in the most positive light possible. For example, by picking certain start and end dates they can easily show their fund’s performance were better than the rest of the market (yet move out by a week or so and the returns can tell a completely different story). To avoid this you always need to independently judge a funds performance against similar competitor funds using a common basis (so that you are comparing apples with apples) and not just rely on the data that is given to you on the fund manager’s pretty looking website.
In order to begin your independent research, I recommend you start with well regarded and unbiased research sites like Morningstar or even Yahoo or Google Finance are not bad to get an initial comparison of various funds based on the following factors: Expense ratio (the lower the better), 5 yr performance (make sure you include this year), Management experience, analyst opinions, ongoing costs and performance relative to a common index of similar funds. Using this basis gives you a good starting point to compare a number of funds and then narrow your search down to two or three that you can delve deeper into. It takes times to get a feel of which metrics work best but with a little bit of playing around and education you can quickly weed out the losers from the winners. If you are completely new to mutual fund investing or want a deeper understanding of the industry and how to pick a good fund then get some basic investing books from your local library. I also recommend new investors stick with well diversified index based mutual funds as opposed to very specific sector or investment type funds, until they learn more about investing and the associated risks.
2. Ensure you minimize the ongoing fees and costs: For smaller investors the biggest drain on their returns (apart from a stock market crash) is the ongoing management fees. Fortunately most mutual funds do not charge money for making regular contributions – though it is normal to ask for a minimum balance like $1,000 to $3,000 to open an account. Mutual fund management costs should be less than 2% and there should be no transaction fees for ongoing investments. I like to use low cost brokers for a lot of my stock and ETF trading because of their free trades, but I have actually found that the best way to invest in mutual funds and avoid any transaction fees is to invest directly with the fund manager. One fund manager that I use regularly, Vanguard, has very low management costs and no fees for regular direct deposits.
3. Taxes and Dividends. Like any investment, you will incur a tax liability when trading mutual funds. Unlike stocks on which your capital gains are easily calculated based of the share price on the buy and sell dates, mutual funds taxation is a lot more complicated. It is based on a whole host of factors related to how stocks/indexes that make up the mutual fund were traded during the year and potential foreign taxes. For an individual investor keeping track of this is near impossible, especially if you maintain your investment for a number of years and reinvest dividends. Luckily all good mutual fund companies provide annual tax statements that state what your tax liabilities (or refunds if you are lucky) are. You can however get an idea of potential taxes by looking at the fund’s prospectus (which is worth reading) that provides estimated taxes based on past years.
Most broad based mutual funds pay some form a periodic dividend (you can specify this requirement in your research criteria when looking for a fund) which can either be taken this as a cash payment or be re-invested. Unless you bought the mutual fund specifically to provide a regular distribution/dividend then I strongly recommend reinvesting the dividend. This form of automatic investing is easy, free and can really compound your returns over time.
I know the above primer on mutual fund investing, based on a number of email exchanges, helped Ben get started on his first mutual fund investment and I hope it gives new investors out there a bit more guidance. Feel free to leave a comment with any questions or other ideas.