Anyone investing in the stock market should know a few basic principles to understand what they are buying into (or what their investment advisor is buying for them). These few points are the bare minimum investors should comprehend before placing any of their money at risk.
- Funds come in two basic types - mutual funds and ETFs. Both are collections of stocks and can help diversify a portfolio. Some are index funds, which means they track an index (such as the Dow Jones, S&P 500, small or mid-sized companies, utilities, foreign companies, etc.). Others are actively managed, which means the fund manager tries to beat these indexes. History shows that few managers can actively beat the indexes consistently, especially after adding in their fees.
- Some mutual funds charge 12b-1 fees. These fees are for the fund's "marketing and distribution" and are used to pay advisors for putting their clients in these fees. (Fee-only advisors are not paid by mutual funds and do not receive these commissions.) Funds that charge 12b-1 fees have not been shown to perform better than low cost and no-load funds. In fact, the extra fee hurts investors' net returns. Funds charge other fees too and can be as high as 1.5-2.0%. Most index funds are lower than 0.5% with many domestic funds under 0.1%.
- Front-end and back-end loads are commissions that are paid from mutual funds to advisors and have no benefit to the investor. Investors should question any advisor who "sells" these funds.
- Funds (ETFs and mutual funds) can hold stocks or bonds or can hold both to further diversify and balance its returns. The same or better diversification can be created by an investor by choosing index funds and the allocation to stocks and bonds that fit his or her risk tolerance.
- Being diversified means investment risks are lowered by not having too much exposure to a single company. Funds spread out this risk by investing in multiple companies (usually more than 100 and sometimes as many as 2,000 companies). Diversifying beyond one index helps reduce risk further because some years one sector of the market rises or falls more than others. By owning different sectors, investors have less exposure in the bad times, but are certain to have some exposure in the good times.
- Deciding which fund or stock to sell each year based on if it did not perform well in the prior year is the opposite of a winning strategy. Investments should be chosen on a balanced and diversified basis with the understanding that different sectors may perform better than others in a given year, but by rebalancing annually the longer-term results will improve. Selling portions of the best funds and stocks to buy more of the funds that did not perform as well creates a buy-low, sell-high set-up. The theory is that the same sector rarely outperforms the other sectors for multiple years in a row, so by taking profits annually, an investor can invest sell while a sector has already had its success and move it to a sector that is poised to rebound.
- Every account needs to be diversified. If an investor has a 401(k) through work, a traditional IRA, and an after-tax brokerage account, each account needs to be diversified on its own to allow for annual rebalancing.
- Many mutual fund and ETF companies invest in the same companies (by sector). This allows investors to invest with the lowest cost provider and diversify on their own or with the help of an advisor. Investing through different fund companies (Vanguard, Fidelity, T. Rowe Price, Schwab, etc.) does not further diversify holdings. The investments made through the funds is what matters.
- Historically, stocks have outperformed bonds, but a portfolio that holds both stocks and bonds and is rebalanced annually tends to perform better over time.
- Investment performance should be judged on risk, income, and growth. Simply because an investment grows quickly does not make it the best choice for every investor. Some investors need to have less risk than a high growth investment might offer. While a riskier investment may have a greater return, it can also have larger losses.
- Dividends have accounted for as much as 45% of the S&P 500's return in the past three decades. Dividends are not just for those investors who are retired. Every investor can benefit from dividend payments. Reinvesting these dividends in the same stock or fund is not as important as using the cash received to help rebalance a portfolio to remain diversified.
- When investing for short-term goals, stocks are too risky in most cases.
I'll cover the pros and cons of mutual funds vs ETFs in another post.
