When it comes to saving for retirement, putting a portion of your nest egg into the stock market is a tried-and-true practice. For many Latinos, one of the best ways to accomplish this is by using mutual funds. In this article, we will explore what mutual funds are, how they work, how to get started, and some common pitfalls to avoid.
Before taking the leap, let’s cover some basic investment vocabulary and principles.
A stock represents ownership in a company. When your purchase one share of Ford stock, currently costing around $11, you literally become a partial owner of Ford Motor Company. Your ownership stake is very small, as there are just under four billion shares outstanding, but the bottom line is that you do in fact own a portion of the company.
There are two ways to make money from investing in stocks:
- The company pays a dividend to shareholders. This represents your share of Ford Motor Company’s earnings.
- The stock can increase in value and you can sell your stock for more than what you purchased it for. Stock prices generally increase when investors feel that the company is going to be more profitable and, therefore, ownership in the company is more valuable.
Diversification – Why It Matters
Consider the example of an investor who puts their entire retirement portfolio into just one stock like Ford Motor Company. If your stock goes up 50% in one year – great, you hit it big and just made a huge step forward towards your retirement goals. If the stock goes down 50% in one year it may put your entire retirement in jeopardy.
This level of risk is unacceptable to most investors, so financial advisors and planners always recommend building a diversified portfolio which contains many different stocks. The idea here is that even if some of your stocks are performing poorly, you should have a handful of stocks which are performing well and can keep your portfolio moving in the right direction.
When it comes to building a diversified portfolio there are two ways this can be achieved:
- You can spend hours doing research on hundreds of different companies. You can then hand pick the stocks which you feel will perform the best over the next one, five, or 20 years. In this example, you do all of the the leg work of building a diversified investment portfolio.
- You can invest in a fund which owns a basket of stocks. The fund is operated by a fund manager who picks the stocks and all you have to do is become an investor within the fund. Similar to owning an individual stock, you can make a return on your investment if the fund pays dividends or appreciates in value.
Option number two is exactly what a mutual fund is. Because mutual funds provide investors with diversification and a simple way to invest, they have become extremely popular in recent years. Let’s now explore some of the terminology specifically related to mutual funds and the different types of funds which exist.
Understanding Net Asset Value (NAV)
In our Ford Motor Company stock example the investor purchased one share of Ford stock. This stock trades on a stock exchange and the price moves higher and lower depending on the demand from investors for the stock. If demand is weak (the company is performing poorly) the price will fall. If demand is strong (the company is performing well or is expected to perform well in the future) the price will move higher.
A mutual fund works a little bit different, and the concept of Net Asset Value (NAV) is critical to understanding how mutual funds are priced. NAV is the cost of buying one share of the fund and is dependent on the funds assets, funds liabilities, and how many shares of the fund are outstanding.
The funds assets are the total value of all the funds investments, plus any cash which is not currently invested. The funds liabilities are things like the fees owed to fund managers, service providers, or interest to lending banks which help finance the fund. The outstanding shares is simply the total number of shares available from the fund manager. The formula looks like this.
NAV = (funds assets - funds liabilities) / outstanding shares
NAV = ($2,000,000 - $100,000) / 100,000
NAV = $19
In this example, an investor would have to spend $19 to buy one share of the mutual fund from the mutual fund company. Likewise, an investor who wants to sell one share of the mutual fund back to the fund company would receive $19. NAV is generally calculated daily after the close of trading on the New York Stock Exchange. It is done after the market close because that is when all of the individual stocks within the mutual fund can be accurately valued.
Types of Mutual Funds
In 2016, there were just over 9,500 mutual funds operating within the United States.1 While this number can seem overwhelmingly - it also means that there are a HUGE variety of funds available for Latinos who are looking to invest. Mutual funds can be broken down into five major categories of funds:
- Equity Funds are mutual funds which focus on holding individual stocks. An equity fund could hold shares in IBM, Ford Motor Company, or Apple - just to name a few. Their primary goal is to hold stocks which are ripe for price improvement.
- Fixed Income Funds are mutual funds which are made up of stocks which pay dividends and bonds. Both of these financial instruments make consistent payments to their shareholders and are used to generate consistent income - many times during retirement.
- Index Funds aim to mimic the overall performance of a stock market index - like the S&P 500 or Dow Jones Industrial Average. While you can’t buy actual shares of the index, you can buy shares in an index fund which aims to track the movement of these indices. These are one of the most popular fund classes available because a single share of an index fund will provide an investor with exposure to hundreds of individual companies.
- Balanced Funds are funds which are made up of a mix of stocks and fixed income instruments like stocks and bonds.
- Speciality Funds are mutual which hold specialized investments - outside of simple stocks and bonds. These funds may hold property, commodities, or only investing in companies which are working to limit carbon emissions.
- Funds of Funds are, as the name implies, mutual funds which are made up of other mutual funds. These are a great way to gain diversification, as you are buying a fund which holds many diversified funds.
Fund Managers and Active/Passive Investing
A big item we haven’t touched on yet is how the actual fund makeup is determined - or who decides which stocks will be in the mutual fund. This person is called the fund manager, and there are two distinct types of managers out there: active managers and passive managers.
Passive managers invest passively, meaning that they have identified a sector of the market they would like to capture and then buy and hold stocks within this sector. An index fund is the most pure passive strategy that is available.
Active managers aggressively look for stocks which will be providing the highest yield to investors. Active fund managers may trade multiple times a day, getting in and out of a specific stocks. Funds which are actively managed have much higher fees because there is many time a team of stock market analysts who are watching the market daily. In this way, an active fund is a great way to get “wall street experts” in your corner. The downside to cative strategies is that many of these active managers fail to outperform passive strategies.
In fact - in 2016 some 66 percent of actively managed funds failed to outperform the S&P 500.2 This statistic, combined with the much lower fees, make passive mutual funds much more attractive to most Latinos.
Fees, Fees, Fees
As we have said before, fees are the four letter word in financial services. When you invest in a mutual fund you will be charged two different types of fees:
- Annual fees for holding your money in the fund
- A transactional fee when you buy or sell shares of the fund
The annual fee for being invested in the fund is called the expense ratio, and is quoted as a percentage. According to the Investment Company Institute, index equity funds averaged an expense ratio of just 0.11% in 2014 while funds that were focused on equity growth cost roughly 0.82%. These fees are clearly shown on any mutual funds prospectus - which is the document explaining the fund, what the fund is trying to accomplish, and how the investments within the funds are managed.
As always, it is critical to understand what type of fees will be charged when you become an investor within a fund. These fees may sound small, but can really dig into your returns over a lifetime of investing.
Looking To Get Started?
There are three ways to begin investing in mutual funds: Through an individual brokerage account, through an employee-sponsored retirement plan, and with the assistance of a financial advisor.
If you are feeling confident about the process and would like to be hands on, opening up an individual brokerage account with Scottrade or E-Trade are a great way to go. If you are feeling apprehensive and would like some assistance, consider working with your employee-sponsored manager or finding a local financial advisor. As always when finding a good financial advisor, it is critical to ensure that they are a fiduciary which is required to make recommendations based on what is in your best interest. As we have said before, working with a financial advisor that is a Registered Investment Advisors (RIA) is a great way to go.
Mutual fund investing can be a great way to gain experience in the stock market and to begin your journey toward retirement. As always, we will be with you every step of the way here at Super Monedero.