Technical Vs. Fundamental Analysis

There are two main types of investment research: fundamental and technical analysis. Investors would do well to be familiar with both approaches.

In fundamental analysis, stock is valued according to the financial data a company reports. These data are analyzed to predict the likely movement of that company’s stock price. At the Common Sense Investor, we tend to prefer fundamental analysis as a primary research method mainly because it gives you deep insight into the strength of a company and its prospects moving forward. Fundamental analysis tends to be the preferred choice of long term investors who can see beyond the temporary volatility of the markets. It is based on the belief that over the long term the stock market is rational, but over the short term it can be overly emotional and not properly reflect a company’s value.

Technical analysis, on the other hand, involves the study of market charts. Instead of looking at the actual reported data, the technical analyst examines the stock’s historical price movement. The underlying premise here is that there are clear and predictable patterns in the market that can be identified and exploited by the smart, active investor.

What’s interesting is that these two methods can paint very different pictures of the same business.

Fundamental Analysis

Fundamental analysis does not ignore market trends, but treats them as only one element in an overal analysis. A company’s financial results over the years, its operations efficiency, the reputations of its officers, and the markets in which they are competing are all elements of analysis. A fundamental analyst may look at dividends and stock value, how cash is managed, level of debt, market share, countries the business operates in, and the growth of revenues and earnings versus expenses.

This is all based on the idea that a company must be fundamentally sound in order to make money over the long run. Graham and Dodd in Security Analysis stated that the market is in no way a predictor of a company’s future performance. It is, instead, a voting machine rather than a weighing machine. Even if the true value of a company is not currently reflected in its market price, fundamental analysis works on the idea that it will eventually come out due to market forces.

Valuation techniques like the P/E ratio and return on equity are often used to determine the true value of a company by a fundamental analyst. But no fundamental analyst depends on these techniques to the exclusion of other data, such as general company financial health and growth or loss of market share.

Technical Analysis

Technical analysis, on the other hand, believes that there is value in the “voting” procedures of market valuation of stock. Many technical analysts think there is more art than science in technical analysis. A technical analyst is not so concerned with why a price is moving than the fact that it is moving in a particular direction or in a particular pattern. Profit can be made in any market if you position yourself to take advantage of the price trend. The simplest form of technical analysis is the idea that you should, with up trends, look for opportunities to buy; and with down trends, look for opportunities to sell.

The three primary beliefs in technical analysis is that first, price action in the market trumps all other things; second, that prices move in trends; and third, that history repeats itself. A pure technical analysis ignores the company itself to look at the pricing of the company and the pricing of similar companies historically to predict trends in market valuation.

The two types of valuation can be combined to make some effective market strategies. For instance, the difference between a stock’s actual value as determined by a fundamental analysis and its value on the market, which is what the technical analysis would reveal, is profit that the clever investor can count on making in the future. There are many other ways to combine the two approaches that may be more valuable than either alone.

Average Annual Return: A Metric For Long Term Investment Performance

Average annual return gives the investor a metric to measure the perofrmance of his own investments and to evaluate the quality of potential investments.

The wise investor should perform a regular, objective analysis on the performance of his assets. Doing such an analysis helps you to overcome the very common human tendency of self-deception; a problem to which investors are particularly prone. As an investor, it is crucial that you take a sober, non-emotional assesment of your investing returns and consider whether you are either underperforming or meeting your goals.

To do such an assessment, the investor needs to have the correct tools. You should be familiar with certain formulas and terms in order to understand more fully the state of your asset portfolio.

The first step, of course, is to remember that the only goal of investing is to maximize your wealth. So, if you are not acheiving significant growth in profits, then your investments are underperforming and your money is not working as effectively as it should.

The next step is to realize that non-cash investments are volatile over the short term, so it is not sufficient to measue the success of your investment based on just a single year’s performance (annual return). Rather, since stock, bond and mutual fund investments are meant to perform well when measured over long periods of time, we need a metric for measuring this peformance.

One of the most important measurements of investment success when it comes to stock, bond and mutual fund investments is the Average Annual Return (AAR). The Average Annual Return is used as a means for making a report on the historical return of a investment. The AAR is determined after tallying the expenses that have been incurred – this includes the administration fees, broker fees, fund management fees, the 12b-1 fees (when applicable), as well as other incidental fees that may be incurred. In mutual funds, these expenses are deemed to be a portion of the fund’s expense ratio. Investors should also know that the Average Annual Return takes into account both reinvested dividends and distributions of capital gains.

The Average Annual Return is the calculation of the simple mathematical mean of annual returns over a specified period of time. Computing for the Average Annual Return is quite simple. All one has to do is to add the annual rates and then divide it by the number of years where the rates were lifted. Thus, the formula is:

Average Annual Return = (sum of annual rates) / (No. of years)

To illustrate, if for the year 2000, the annual rate is 10 per cent, and then it becomes 5 per cent the following year, then the average annual return for those two years is 7.5 per cent. The computation for the Average Annual Return clearly shows that this is not a compounded rate of return. Rather you first have to calculate the annual return for each year individually (10, 5), then add each annual return together (10 + 5 = 15), then divide by the total number of years (15/2=7.5).

Before we conclude this essay, here’s an article on how to use our annual return calculator to calculate the average annual return. Go ahead and give it a shot. Practice makes perfect.

Ok. It should also be clearly noted that the computation of the Average Annual Return will only include such expenses like sales commissions, if these factors are explicitly factoried in as part of the computation (in other words, when calculating the annual return, you may have to manually subtract various fees from your total return). To make things as easy as possible, you should always try to look at the bottom line figures: 1) how much did I start out with and 2) how much did I end up with.

The Annual Average Return can be a good barometer for determining the change of an investment over a period of several years. But investors should be careful how they interpret the Average Annual Return metric. Here’s what to look out for.

First, keep in mind that the average annual return can be artificially inflated by a single “lucky” year. You never want to go with an investment that is normally bad, but occassionally gets lucky. Say a mutual fund, over a 5 year period, has returns like this: 70%, 6%, -10%, -8%, 3%. This fund has an average annual return of 12.2%. On first glance, that looks pretty good. But notice that the number gets ridiculously inflated by its first year 70% return. As we see from the next four years, the fund’s first year was a fluke.

In addition to average annual return, you need to keep an eye on consistency and also calculate the average annual return over several three, five and ten year periods.

How Do Dividends Work?

Sometimes companies give some of their profits directly to their investors in the form of dividends.

Dividends are the cash payments stockholders receive based on a company’s earnings. Not every company pays dividends, but you’ll find that a large portion of established stable companies do. Dividends are the only way, apart from using strategies around options, that an investor can profit from his stock without selling off his shares.

Profits made by a company are spent in one of two ways. They are reinvested into the company to promote growth, with the idea of creating more profit and more robust stocks in the future. And they are distributed to shareholders as dividends. Reinvesting for growth is only viable as long as the company is growing at an above average pace.

Every company, however, will at some point reach a plateau, where they are not significantly increasing profits or customer base. Now they are no longer justified in reinvesting money; it’s not working to grow the company, and reinvesting it may just be throwing it away. At this point, most companies start paying dividends to their stockholders.

An example is Microsoft, everyone’s favorite investment. It was inevitable that at some point they’d reach market saturation; there are a limited number of computers to put Windows on, and a limited number of people to buy them. What happened at Microsoft was a limitation of projects. They had dozens of projects, but they didn’t need any more money to fund them. Instead of putting money into worthless projects or padding the budgets of existing ones, in 2003 Microsoft opted to start paying a dividend to shareholders.

Once a company starts paying dividends, you can expect its growth to decrease. That doesn’t mean it is suddenly a worthless company. It means, rather, that it will no longer grow in leaps and bounds. Sometimes it can be a good idea to invest in a dividend-paying company because dividends can be a reflection of the general health of the company, their stability, and their profitability. Dividends can also be viewed as a guaranteed bit of return on investment that’s not dependent on market swings.

But dividends do not always signal a good investment, so you should be careful. In particular, dividends are susceptible to immediate rather than deferred tax. When an investment distributes a dividend, you must pay tax on that dividend in the same year. However, if your investment is earning by shear capital appreciation, your tax is deferred until you sell the stock. Non-dividends, therefore, give you more control over when you pay the taxes.

You should watch dividends compared to the company’s income. A dividend payout of over 50% of the company’s net profit may be a signal of danger; even large stable companies have research and development to invest in, and when they choose to pay stockholders rather than try to grow their profits, it may mean they are worried about the health of the company and anticipating a stock selloff.

Remember, though, that earnings are not as secure and solid a number as dividends. Even with Sarbannes-Oxley, aggressive accounting practices warp and twist numbers, and you must be vigilant for this problem.

And if a company has paid dividends for a long time, then suddenly stops, you can expect a panicked selloff of stock by some shareholders. This is seen, fair or not, as an announcement that a company is in trouble. Even though a company doesn’t have to pay dividends every quarter, most companies that start paying them do everything possible to remain able to pay them. Keep this in mind, because once a company starts paying dividends, it is much harder to reverse course and instead put the money towards company growth.

Why does the Mutual Fund NAV price go down when dividends are paid out?

We’re often asked, “Why does the share price of the mutual fund go down when dividends are distributed?” Here’s our answer.

The NAV is the Net Asset Value of a mutual fund – that is, it is the total value of the assets within the mutual fund. It is a value that adjusted daily based the way stocks in the fund’s portfolio fluctuate. It might even help to think of the NAV as a “meta” stock ticker: it captures an overall picture of all the holdings of a mutual fund and is adjusted daily. Because of market changes, your NAV today is likely to be different from your NAV tomorrow.

Finding the NAV

A shortcut to finding the NAV that’s usually accurate is to assume it’s the price per share; this is usually, but not always, correct. The NAV is recalculated every day based on changes in securities that are held in the mutual fund; in contrast, stocks change prices by the second based on market demand.

To calculate, you simply take the current market value of all securities held by the fund minus any liabilities, and then divide this number by the number of outstanding shares. This is Net Assets / Outstanding Shares.

What the NAV Is Good For

Unlike standard stocks, a number like NAV that seems to reflect the value of a fund in the market doesn’t work quite the same way for mutual funds. Legally, mutual funds must distribute at least 90% of realized capital gains and dividend income annually, and when a mutual fund pays out this cash, its NAV will drop by the same amount.

This is something that frightens investors that don’t realize it’s coming, and they may sell off the mutual fund without investigating further.

But that’s not what’s happening. A sudden drop in apparent value because the NAV has dropped does not mean the investor has lost money; rather, that value has been paid out to the shareholder. To maintain portfolio value, you simply have to make sure the dividends are reinvested back into your fund.

In general, you can expect your NAV to change every day, but it does not change every minute. The NAV is not a good way to assess how your mutual fund is doing; instead, you should track the overall annual returns of your funds. As long as you are reinvesting your dividends, you can do this by simply calculating the growth of the overall value of your fund. In the end, that’s what matters after all, isn’t it? Instead of tracking the direction of the NAV, you get a much better performance assessment by simply tracking how well your fund is growing. This gives you a better handle on performance.

What Should I Look At Instead of the NAV?

First, read the prospectus and the annual reports of the mutual fund. These will give you a good idea of earnings and growth for that fund, and how robust it is.

Second, remember that the NAV is affected by two things: the payout and the fact that many mutual funds are always open to new shareholders – which means more shares may be sold, which changes the divisor in the NAV calculation.

Since this makes NAV less than reliable, start looking inside the fund. Look at the larger stock holdings, and take a look at their P/E, P/C, ROE and other metrics. Learn a little about what they mean. Though most people buy mutual funds as a shortcut, so they don’t have to worry about these numbers, when you first buy one knowing that your mutual fund buys only the best stocks reassures you that you’re picking up a mutual fund that’s good for the long term.

Investing and the Psychology of Self-Deception

The key to avoiding self-deception is to find an objective way to measure overall performance and then act on the results.

I’ve got to confess. There have been times in my investing career when I’ve been the victim of self-deception. What does that mean? It means that I’ve misled myself into thinking that my investments were better than they actually were.

Self-deception is one of the marks of human psychology. Playing the lottery or gambling are cases of positive self-deception: the illusion that somehow you can overcome the odds that are stacked against everyone else. “I’ll give it one more shot. I have a good feeling about it this time.”

Self-deception works in both directions. For example, social introverts perceive themselves more negatively than the rest of the world. They can be self-deceived into thinking that they and the things they do are worse than they actually are

However, when it comes to investing, the far more common form of self-deception goes in the positive direction. It’s much more comfortable to evaluate a stock’s performance when that stock is doing well and to ignore the stock’s performance when it is doing badly. It’s also a lot easier to only focus on your investing successes while ignoring your failures, without capturing an objective, overall view of your performance.

One of my friends is a very active trader: he likes to throw his money around on the stock market and he rarely buys to hold. He has almost all of his money (about $500,000) tied up in stock investments. Now, with $500,000 you’re not doing a good job at investing unless your 5 and 10 year average annual returns are above 10%.

Unfortunately, my friend is in the grip of self-deception. Last year he lost over $6,000 on his investments. The year before that he only made $8,000. He’s never hit the 10% mark over a single 5 year stretch.

Despite these poor performances, every time we talk he only wants to focus on those few “hunches” that turned out to be winners. He never wants to take an objective, overall look at his investment performance, which is an utter failure. He doesn’t want to face up to the fact that he’s a bad investor.

Investors are human beings. And human beings don’t like to be wrong. But when it comes to investing we really don’t have a choice. We need to be honest with ourselves and do objective investment analysis.

Doing an objective analysis of your investments doesn’t have to be uber-difficult. The key is to detach 1) the time of analysis from 2) the specific performance of your investments. What you need to do is schedule two equally separated days a year to perform a 5 and 10 year analysis of the average annual returns of your combined investments. This will give you an overall picture of your investment strategy.

To get a more micro-grained analysis of each particular investment in your portfolio, simply perform a 5 and 10 year analysis on each separate investment vehicle. Those assets that consistently and dramatically under-perform should be moved into investments that consistently out-perform. Now, there is a danger that you should avoid here and the key word to focus on is consistently. Don’t throw your money into investments that have done well just in the short term and don’t pull your money out of investments that have just done badly in the short-term.

At the end of the day, investors need to guard against self-deception or else the consequences will be visible in terms of the dampening of your wealth. The aim of all investing is to maximize wealth, and if you’re sitting on poorly performing investments, then it’s time to take action.

Financial Advisors: Do You Know Who Runs Your Money?

The key to finding a good financial advisor is doing your homework. Make sure he has a solid track record and an understandable yet principled approach to investing.

Many people today feel that they’re not qualified to invest their own money; that’s understandable, given how complex the investment world has gotten. But do you really need a financial adviser and will he really help your investment returns in the long run?

As usual, the answer is “that depends”. There are good financial advisers and there are bad financial advisors (they are normally nothing but “salesmen”). A few can probably manage your money much better than you could on your own, while many others can do a lot of damage. The fact of the matter is that by using common sense investing principles, you can really do a better job on your own than with the average financial advisor. Nonetheless, not everyone has the time to do the necessary work involved to become a successful investor on their own. In these cases, you’ll need to find someone who can do your money management for your.

Here are some things to look out for in a potential financial advisor before you sign the contract with him.

You should trust him. Your money should be your lifetime concern, and you should ask the same of your financial advisor. When you’re talking to a potential financial advisor, ask yourself if he seems like the sort of person you can trust with your most valuable assets for the rest of your life. If he seems like a car salesman, then just walk away.

Your adviser should probably work on a fee structure rather than commission. Fee-only advisors avoid a conflict of interest in that they don’t get you to buy bad investments for their benefit. Commission-only financial advisors make money only if you buy something, and that’s not always in your best interests. Unless a commission-only advisor comes highly recommended by someone who’s worked with him for years, you should skip him.

Credentials should not be a series of letters, but rather recommendations and a great track record. There is no standardization of credentials in the financial advising field. You should also look for a federal securities license, state insurance, and registration with the SEC or the state equivalent.

You should never let your finances get tangled with your financial planner’s. He should never accept a check for investments you write to him or his firm, or be listed as a joint owner or beneficiary of any of your financial holdings. He should also never ask for or accept discretionary authority for your finances, especially if he works on any kind of commission structure.

If your prospective financial advisor offers you an exclusive deal that only his firm can provide, you should probably look for a different advisor. A deal like this generally works by providing a fee to the financial advisor for finding investors, and it’s a conflict of interest for the financial advisor to carry it. In general, these advisors aren’t interested in what’s good for you.

When you interview your prospective advisors, find out how long they’ve been financial planners, and ask about their track record. If they haven’t been advising long, find out what in their background makes them competent to invest your money for you. Is the advisor’s office staff small but efficient? Is the office neatly kept, or are there piles of papers everywhere? You want neat and efficient; they’re handling your money!

Check up on their record with the SEC and the NASD. And especially if you’re looking at more than one financial advisor, ask what they think of the others. If anyone is very disparaging of the other advisors, he may be the one to avoid!

When you talk to him, does he make sense to you, and take the time to explain things to you thoroughly? And has he been in the financial advisory business for at least five years? Does he have a large client list, and does he handle assets into the millions?

Whoever you agree to work with, your contract should have a built in cancellation option, so you don’t get stuck with a bad advisor for a prolongued period of time.

Finally, if you want many of the benefits of a financial advisor without most of the fees, consider putting your money in a well-managed mutual fund. While you may lose some of the immediate person-to-person contact, finding a good mutual fund manager is as easy as finding a good mutual fund. And a mutual fund’s long term track record is much easier to track than a run of the mill financial adviser.

I Have Ten Thousand Dollars, How Should I Invest It?

Where to start when investing?

This is one of the most common questions that we see asked by beginning investors, especially those who have just come upon an extra ten thousand dollars (wouldn’t it be nice if it happened to more of us!).

Are you ready for an unconventional, but simple answer? Ok, but first let’s be clear about what you don’t want to do!!! Do not put your money in bonds (even if you’re over 50*). Do not put your money into savings accounts. Do not try to play the stock market like a game. Do not overdiversify by spreading your money across too many investments. Don’t invest blindly!

So are you finally ready for the answer? Here it is: spend a lot of time researching great mutual funds that invest in the stocks of well-run companies and select only 1-3 funds with excellent managers to entrust your money to. Now selecting a great fund takes a lot more work than the average person initially thinks. There are a number of criteria to look for and a number of mistakes to avoid when finding a good mutual fund. But it can be done and the payoff will be huge. You want your money to grow as fast as possible, right?

Finding the right mutual fund is the key for an inexperienced investor who finds himself with a stash of cash ($10,000 or so) and wants to use it wisely to maximize profit growth. Investing is not a game of chance. It is not like gambling. It’s really not even like poker where chance supersedes skill. Investing should be disciplined and focused and if done correctly can provide consistent high-yield returns. But as a beginning investor, it is probably best to find a professional who knows how to make it happen rather than trying to work the stock market yourself.

So how do you find good mutual funds? Well you can start from the Money 65 list and narrow it down from there.

One last recommendation. If the stock market’s been hot for a while, consider trickling your money in by way of dollar cost averaging insteading of dumping it in as a lump sum.

Note: we do not consider all the funds on the Money 65 to be good funds, though many of them are.

*We believe strongly that for any period of time greater than three years, the best place for your money is in a well-managed, long-term mutual fund.

Keeping Track of Mutual Fund Expenses

The first step is to understand mutual fund expenses. The next step is to avoid them!

Mutual funds are designed for people who want to minimize risk and volatility in their investments, maximize purchasing power by pooling their resources with others, and minimize the costs inherent in buying and selling stocks. But you might be surprised that not all mutual funds have low expense ratios: many of them charge you what we feel are excessive fees. The common sense investor needs to be aware of the fees and expenses involved in any mutual fund investment.

It turns out that mutual funds that are actively traded can have surprisingly high expenses. This is reflected in their turnover costs. Actively traded mutual funds have an active manager who pays attention to the markets and will buy and sell stocks based on performance. This sounds like a great idea (we all like to know that our money managers are working for us), but actually results in increased costs.

Note: not all actively managed mutual funds have high turnover costs. Some fund managers believe in buying for the long-term and these will, subsequently, lower turnover costs.

Turnover

Turnover is a measure of the volume of buying and selling that’s gone on in the mutual fund management. High turnover is something you should pay attention to in mutual funds. Make sure you always get turnover figures when you’re looking at prospective mutual funds. You’ll always see a difference in turnover between actively managed mutual funds and index-based mutual funds. For a benchmark, index funds often have fees of around .2% per year; managed funds are more likely to fall around 1.5%, a 1.3% difference. Add in the taxes, and you can see that a managed fund needs to perform significantly better to buffer the additional expense.

Low turnover in a managed fund is indicative of a long-term investment philosophy. At The Common Sense Investor, we think that the best investment philosophy is the one that sticks to the fundamentals of long-term investing. By looking for strong long-term performance but low-turnover, you can identify actively managed mutual funds that outpeform index funds. As always, stay away from funds that seem to be treating the art of investing like a game. High turn-over can be indicative of poor discipline and poor long-term vision.

Watch for this: the turnover value is sometimes divided in half because one security is sold and one bought in the same transaction. The standard measure requires both to be counted as one each. If your actively managed funds appears to have suspiciously low turnover, ask about this. Look at your management fees, too; they can be from .5% to 2.5%.

Managers who depend on commissions to make their profits are more likely to engage in high turnover management. This is usually a conflict of interests. If you find your mutual fund does this, run the other direction and get out as soon as possible!

Taxes, Taxes, Taxes

In addition to resulting in higher fees and commissions to managers, high turnover also results in higher taxes for the fund, which of course are passed on to the investor. Capital gains tax from selling an investment turns into taxable income when distributed to investors.

Loads

In today’s market, load funds should almost always be shunned and avoided.

Front-end loads are commissions a mutual fund pays to a broker when shares are purchased. Really, you should avoid loads altogether, but if you’re attracted to a load fund, watch out to be certain these aren’t too high. If you don’t pay any up-front fees, ask about how high the back-end load is; you’ll pay for it when shares are ultimately redeemed. A few funds, though, use a level-load fund, which only charges you a back-end load if shares are sold within a year. Watch out for loads; they’ve been known to be as high as 8.5%!

There are also mutual funds with no sales charges called no-load funds, and these are generally sold directly from mutual fund companies or by discount brokers for a flat transaction fee or no fee (if it’s a no-fee, it’s likely that the fund paid the broker’s commission, so check these out especially carefully.) Vanguard, T.Rowe Price and Fidelity are good no-load index fund companies.

Management and Maintenance Fees

If you have an actively managed fund, then chances are there are several employees whose full time job is to support the fund’s existence. They’ve got to be paid somehow. Normally, their salaries are usually drawn directly from the fund either as a percentage of total assets or as a percentage of total performance. Similarly, someone has to pay for office space for these employees and for other costs such as media exposure, investor relations, trading fees etc. These expenses are usually not taken from the individual investor, but get extracted from the overall fund.

Index Funds

If minimizing fees and expenses is your goal, than index funds are the way to go!

Index funds are mutual funds that, rather than being actively managed, are tied to a specific index, like the Dow Jones or S&P 500. These mutual funds have significantly lower expenses, but are not likely to perform quite as well. Index funds are more likely to be very general and diversified, and are good for long-term investors looking to minimize costs and volatility. The shortcoming of index funds is that they tend to not be selective between good and bad companies, and rather come close to investing blindly in a wide array of companies, some of which are good and some of which are bad.

While it is true that actively managed funds, averaged out, have historically not returned as much as index funds, we believe that you can beat the return of index funds by honing in on a no-load, low-expense, extremely well managed fund that has historically beaten the indexes by several percentage points.

Pitfalls of Mutual Funds

The pitfalls of mutual funds

Just like any other form of investment, mutual funds also offer their balance of advantages and pitfalls. The common sense investor should always be aware of the potential downside to any investment medium. If you have plans of investing in mutual funds, keep these pieces of advice (and pitfalls to avoid) in mind.

There is real danger of overdiversification

Diversification is a good attitude when it comes to successful investing but there is a danger when mutual fund investors go overboard and overdiversify. Diversification aims to reduce the inherent risks that are associated with holding a single security or type of fund. Overdiversification involves two things. First, it occurs when an investor gets many funds that significantly overlap each other’s holdings thereby not really receiving the benefits of risk reduction given by diversification. Second, overdiversifcation can result in a drag on your overall return. By having too many poor-to-mediocre funds, the investor loses out on the return potential of a few well-managed funds.

It should also be pointed out that buying mutual funds does not automatically mean that you have diversified your investments. If you have funds that concentrate only in a particular market sector or region then you are still relatively at the same amount of risk.

The danger of blind diversification

One of the most pervasive errors in the investment industry is the view that you absolute must diversify across industries and asset classes. Many mutual fund managers buy into this philosophy. In fact, the whole phenomena of Index Fund investing is a reflection of this view.

At The Common Sense Investor we think this philosophy results in watered down returns and unintelligent investment practices. Your mutual fund should employ a strong investment philosophy that takes advantage of the fact that good companies will, more often than not, use your money wisely. But if you’re not seeking out good companies with your investment money, then who knows how your money’s being used.

The danger of passive investing

When you invest your money in a mutual fund, you are entrusting your money to a particular investment philosophy (either a manager, an index, an asset class, etc.) However, there is a danger that in entrusting your money to someone else, there is also a corresponding tendency to put blind faith in their ability to perform. The common sense investor needs to actively monitor the performance his funds and the investment philosophy that they employ.

Mutual funds give fluctuating returns

Mutual funds are like other investment options in that they do not offer a guaranteed return. There is also the slim possibility that the value of the mutual fund you bought will depreciate. Mutual funds also experience price fluctuations along with the stocks that make up the fund, not like bonds and treasury bills, which are more or less fixed-income products. The good news is that there are proven and consistent methods for using mutual funds to outperform the return of bonds and cash investments. But it is essential to research the fund you will be investing in. Just because a fund manager will be overseeing the fund it does not mean that it will be a strong performer. Rather, the long-term returns from a fund are a direct result of the fund’s investment philosophy: so choose a good one

Always remember that mutual funds are not guaranteed by the US government. This means that in the case of dissolution, you will not get anything back. This against reinforces the need for investors to do their homework and pick a consistently strong, well-managed fund with a long track record of superb earnings.

Money sitting around and not working for you?

Mutual funds, as you well know, accumulate and pool money from thousands of investors. This means that everyday investors are putting in and withdrawing money from the fund. In order to maintain this practice they have to keep a large portion of the money as cash. But having that amount of money is lying around, although great for liquidity, is not that good considering that this money could be used to work for the mutual fund and thus ultimately more advantageous for everyone. Look for funds with low turn-over and a low proportion of cash to stock.

Mutual funds can be costly

Mutual funds already provide investors with professional management. But this comes at a cost. Funds, in order to maintain its service, will have to charge different fees that would ultimately reduce the overall payout to investors. What’s more, the fees are charged to investors regardless of the performance of the funds – so in times where the fund is underperforming, the fees might only further magnify the monetary loss.

Conclusion

Having reviewed the various disadvantages to and potential pitfalls of mutual funds, we believe that mutual funds can and should be an essential component of the common sense investor’s overall investment plan. The key point throughout is that you have to take an active approach to mutual fund investing: only choose funds that have consistently strong long-term performance with a solid investment philosophy. And never forget to actively monitor each fund’s performance at least once a year.

Benefits of Mutual Funds

The Benefits of Mutual Funds

Ever since they were formed, mutual funds have been a favorite investment choice for the average investor. Mutual funds are simple, cost-effective and they offer a level of diversification that one simply does not get in an individual stock. With mutual funds, you entrust your money with a good financial professional who should in turn use an intelligent investment strategy to pick stocks of good companies at reasonable prices. Below, we go into detail about some of the primary benefits of mutual funds and how they fit into the common sense investor’s strategy for building wealth.

Be warned: not all mutual funds are created equal. The common sense investor needs to seek out those mutual funds that are run by established managers with consistent track records and solid investment strategies.

Getting mutual funds gives you professional management

Buying mutual funds also means choosing a professional money manager who will use the money you have invested to buy and sell stocks. So rather than you doing the research for making investments a mutual fund’s money manager will do it in your behalf. This doesn’t get you completely off the hook, though! You still need to do research on the professional money manager and mutual fund that you pick. Don’t get stuck with a mutual fund dud. Make sure that the mutual fund expenses are low, that the money manager has a proven, consistent track record (don’t fall for a one year anomaly that artificially inflates his performance), and a sound investment philosophy.

Mutual funds offer asset diversification

There is one rule that investors of all persuasions have taken to heart is selective asset diversification. This simply means mixing the investments in a portfolio as a way of managing risk. There is much higher risk that one company will do poorly, then there is that 20-30 well-chosen companies will do poorly. Keep in mind that diversification is worthless if you diversify into a lot of bad investments. Still, there are some basic principles of diversification to keep in mind. As already mentioned, you can diversify into different companies, but you can also diversify into different economic sectors (e.g. technology, manufacturing, industrial, energy, etc.) and asset classes (e.g. large company, small company, foreign company, etc.). Regardless, always choose well-run companies at reasonable prices.

To illustrate this point, an investor decides to buy stocks in the manufacturing sector but also offsets that exposure by buying stocks from the industrial sector as a way of reducing the actual impact of the investment. In other words, if the stocks bought in the manufacturing sector depreciated, your other stocks would generally remain unaffected – independent of the movements in the previous sector’s market. To truly achieve the benefits of a diversified portfolio, you must buy stocks with different capitalizations in different industries. The Common Sense Investor does not recommend diversifying into bonds or cash because 1) they simply do not meet the objective of reaching your highest possible return and 2) companies work for their shareholders, not their bondholders.

Doing the research and developing a strategy for diversification can be tedious, time consuming and definitely costly.

But with mutual funds, the diversification is more or less built in. You get the instant diversification and asset allocation but without having to shell out a big amount of cash. Just make sure that you pick good mutual funds. There are a lot of duds out there.

Mutual funds offer good economies of scale

When investing in mutual funds you can take advantage of their buying and selling size – and this can reduce the transaction costs to your benefit. Buying mutual funds allows you to diversify without having to pay a lot of commission charges.

Mutual funds are offered at lower denominations

Investors usually don’t have the exact amount of money to buy round lots of securities. A round lot of stocks would usually fetch for a high price. But it is easier to purchase mutual funds because it is usually offered in smaller denominations. This means investors with limited funds don’t need to wait to save up to afford getting into an investment opportunity.

Mutual funds are liquid

Another advantage of mutual funds is that you can get in or out of this investment relatively easily. You can sell mutual funds at any time without any penalty because they are liquid like regular stocks. The price of mutual funds is determined at the end of any trading day based on the value of its holdings. The price of any sale is determined by next market close and you can expect to receive your funds within 48 hours by EFT.

Mutual funds make systematic investing easy

Most mutual funds will allow you to set up what is called an Automated Asset Builder to regularly take a set amount of money out of your bank account and invest it in the fund. This makes investing automatic and systematic, a necessity for the common sense investor. It also enables you to take advantage of a natural investing strategy called dollar cost averaging.

In summary, the benefits of mutual funds are many and they make a lot of sense as an investment vehicle for individuals who don’t have the time or money to be active investors. They provide opportunities for instant diversification, strong money management, low-minimum purchases, easy systematic investing and the virtual liquidity of an online checking account. By doing your research once to find a trustworthy and proven money manager, you can reap the rewards of rational investing without doing all of the work yourself.