Roadmap to Riches   
how to invest your 401(k)
Mutual Funds: A Window of Opportunity
Where can I find an investment guru I can afford?
If investments in stock appear to represent one of the better approaches to long-term success in retirement planning, the average investor needs access to a means of investing that taps into the “know how” of seasoned professional investors...investment managers with proven track records of success in the stock markets. To be practical and cost effective, the services of these advisors need to be available with ease and minimal cost.
What are Mutual Funds?
Mutual Funds provide the opportunity to invest in a professionally managed investment pool that purchases stocks in hundreds of different companies across the country. As you contribute money into this pool by buying shares in your mutual fund, you effectively buy a percentage of all stocks owned by this pool. Every single business day, the value of the entire pool is calculated based on the price of each share owned by the pool on that day. The total may be hundreds of millions of dollars. You actually own what would be a small percentage of all those stocks and the value of your investment would go up or down on a daily basis as the stocks owned by the pool change in value. If you want to cash in your account, the mutual fund company sells enough of the stock it owns to generate the cash needed for a disbursement to you on that day.
The advantage of a mutual fund is that it offers the novice or small investor some access to the best investment managers in the world. It also offers diversification so that even small amounts of money are spread out over hundreds of different stocks. This reduces risk by spreading eggs out over many baskets. Finally, there is the protection afforded by the fact that the underlying stocks purchased by the fund secure the investment. The investor’s account is always worth its proportionate share of all the stocks owned by the fund. Every stock owned by the fund would have to drop to zero in value before the mutual fund would lose everything. The collection of stocks and/or bonds in a mutual fund is referred to as the fund’s portfolio.
How Do Stock Market Mutual Funds Compare With Bond Funds And Money Markets...Return-Wise?
If you had invested $1,000 in an S&P 500 Index mutual fund 10 years ago, that would have grown to $6,200 today according to Morningstar, a mutual fund tracking service. By comparison, the same $1,000 invested in U.S. Government Treasury Bills would have grown to $2,100 in the same ten years. $1,000 in a savings account at 5% per year would have grown to $1,600. Some top ranking funds could have turned your $1,000 into almost $12,000 in the same period.
That’s An Amazing Difference.
How Do The Professional Managers Do It?
Managers review specific industries and monitor prices of the stocks in those industries. They tap vast resources of data not practically available to the small investor. They monitor, for instance, the buying and selling activity of corporate officers (known as inside sales) which is public information by law. They also monitor the macroeconomic scene to determine major economic swings and to assess how these will affect stock values.
In some cases, a diligent money manager will monitor the activity in the parking lot of a new company to see how many employees are working late at night and after business hours. This is seen as a measure of the degree to which the company’s product is an obsession with employees, or are they viewing their work experience as just another job. Obviously, we average investors do not have the time for this level of “hands on” company research, and the money we effectively pay to have mutual fund managers perform chores such as this is probably the best money we could spend.
Diversification - It Lets Us Sleep At Night
A major factor in overall success is diversification. While one stock may prove to be a loser, the gains from others can more than offset the loss. The individual investor would find it impossible to achieve the diversification offered by participation in a mutual fund. One twenty dollar investment in a mutual fund can represent the ownership of hundreds of different companies. Of course, our twenty dollars would mean that we had only six cents worth of Apple Computer and two cents worth of Coca Cola, and so on…depending on what investments our mutual fund happened to hold.
When A Little Interest Means A Lot
Each additional percentage point of interest earned, over time, can translate into millions of extra dollars in the future. The following matrix illustrates even further, the extent to which this is true:
$10,000 Per Year Contributed Over 24 Pay Periods
The stock market, historically, has averaged a 6% per year better rate of return than money market funds (or U.S. Government short-term Treasuries). If this is the case, why would anyone with at least 20 years until retirement choose to relegate themselves to a money market fund at 5% versus the stock market at, say, 10%?
What Are Index Funds? Are They Different Than Mutual Funds?
Index funds are mutual funds too, but they are a type of mutual fund that is set on “automatic pilot.” This means that there is very little active management of the money along the lines of what we have described above. Instead, the fund managers just buy a broad cross-section of companies that represent a mirror image of our economy as a whole and no further trading or stock-picking is done.
For instance, if General Motors represented five percent of our country’s economy, than an index fund would have 5% of its assets invested in General Motors stock. That’s it. No hanging around in parking lots to try to determine the next “winner.”
- Index funds come in many forms today depending on what portion of our economy the mutual fund wants to reflect. There are so-called S&P 500 index funds that mirror the largest five hundred companies in the country. There are small company index funds and bond index funds. It’s possible to find an index for just about every subset of the economy that comes to mind.
- The advantage of index funds, and the reason they have become so popular in recent years, is that they do not cost very much to operate. There are no investment geniuses earning multi-million dollar fees, and there are very few trading costs because stocks are not being bought and sold or “churned” in the portfolio.
- In theory at least, the advantage of index funds is that their lower fees and costs more than compensate for the fact that the money is not being actively managed. The theory holds that 70% of any stock’s performance, (up or down in value) is a result of what the stock market as a whole is doing. The best and brightest money managers in the world will be looking at a 70% probability of losing money if the stock market is heading down.
- Index funds have their roots in the so-called “efficient markets” or “random walk” theories which were developed by some professors who threw darts at the Wall Street Journal and hypothetically invested where the darts fell. They proved that by using a “buy and hold” strategy on randomly selected stocks, they could outperform over 80% of all actively managed portfolios over long periods of time. This dart-throwing experiment led to five different Nobel Prizes for economics.
The Bottom Line
Mutual funds offer a window of opportunity enabling us to invest small amounts of money in giant pools that have even more economic clout than wealthy people like Bill Gates or Donald Trump. Armed with this valuable tool, investing can become as easy as learning how to swim or drive a car. It’s important to appreciate how just an understanding of the fundamentals will generate better overall investment results than those achieved by others who spend time becoming self-styled investment experts. As Earnest Hemingway once said, “Some intellectuals are the dumbest people I know.” The investment world is littered with people who have “lost sight of the forest because of the trees” and whose investment results have been dragged down by indecision or an effort to be too clever.
Applying basic fundamentals is much more important than knowing a lot about company finances, the stock market and the economy.
We want to choose an investment mix that offers the maximum returns at a level of risk we can tolerate. As a general rule, the more volatility (periodic losses) we can accept, the more profits we can make over the long term. However, there are some refinements in investment technique that can increase profits without increasing risk. The ideal investment mix incorporates some of these techniques, and the balance of this book will help us identify and incorporate these tools as we select our investments.
Creating the Successful Mix
The key to a successful investment mix starts with a clear understanding of your objectives and moves from there to a selection of investments that fits your needs and your personality. Since there is no single investment that offers high returns with low risk, the job is left to you to create a mix that meets your rate of return at a risk level with which you can live comfortably.
Diversifying or spreading your 401(k) money across different types of investments can reduce your risk and help you create what we can call your “Path of Minimum Regret.” In financial circles, this is officially referred to as “the efficient frontier.” It is the point at which you have taken your maximum allowable risk and your investments are set up to generate the maximum rates of return that could be expected from that risk level.
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