Friday, March 20, 2009

Mutual Funds and Exchange Traded Funds

Wait.... don't touch that dial! I know it's not a very titillating topic, and I also know that stock investing isn't very fashionable at the moment, but for the sake of long-term financial health it is a subject that everyone should know a bit about.

Have you ever found yourself with a little windfall of extra money and no idea how to invest it? Where did that money wind up? I think that most ordinary folks are a bit intimidated at the idea of picking stocks. How do I tell the good companies from the bad ones? When is the "right time" to buy in? For that matter, how do I even conduct the transaction?

Well, I'll let you in on a little secret: even the majority of professional economists and financial planners don't do much stock picking for their own portfolios. I don't either. In fact, I confess that I have never traded stock in individual companies, yet I have been investing in the stock market for over 15 years. How is that possible? Through mutual funds and exchange traded funds (ETFs). Basically, a mutual fund or ETF is a large pool of money contributed by many individual investors and managed by an individual or team of stock pickers, who do the research, make buy/sell decisions and handle the transactions on behalf of all the investors. Both mutual funds and ETFs charge a fee to their investors for this service. The fee for ETFs tends to be lower, but additional fees are charged for each transaction, so if you plan to buy or sell often, a mutual fund might be cheaper.

There may be several reasons that so many financial professionals choose mutual funds and ETFs over individual stocks. They may be trying to avoid potential conflicts of interest, or they might not have enough time to do adequate financial analysis and tracking of each investment. But I suspect the main reason is that they know the odds are against individual stock pickers. A lot of research shows that even the best professional stock pickers have a very hard time outperforming the stock market as a whole over the long run, so why not just settle for a mutual fund or ETF that samples the whole market? These are called index funds. They are cheap to manage, cheap to invest in, and that's where I keep most of my money.

Mutual Funds and ETFs can tremendously simplify the investment process for you, and offer you great diversification through one simple investment. All of these funds are consumer-friendly, with 1-800 numbers, nice websites, and easy to read statements. There are thousands of funds to choose from, and many considerations in choosing a mutual fund or ETF, but first I recommend reading my previous blog entry on the subject of fees, and then doing a little reading up on the subject of managed vs. index investing.

Yes, the stock market involves risk. If the phrase "past performance is no guarantee of future results" has scared you off in the past, think of what that ironically means today: next year might be a great year for stocks! The fact of the matter is that stocks still outperform every other kind of asset over the very long run, so it's unwise to dismiss stock investing entirely.

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