The only mutual fund you should buy is an index fund.
The first and still the best known of these is the Vanguard 500 Index Fund. As the name implies, this mutual fund mimics the S&P 500 index. Why is investing in the S&P 500 a good idea? Because historically, it has averaged 11% annually. How many mutual funds can beat that? Not many.
Here are some more reasons why you should only invest in an index fund:
80% of mutual funds under perform the S&P 500. Scary, but true. Why waste your time trying to find one that’s going to do better, when there is an 80% chance you’re going to be wrong?
Index funds have significantly lower management fees. Having a highly qualified team to pick the fund’s stocks is expensive and it eats into the profits. An index fund doesn’t have to do any research; they just buy and sell the stocks to match the S&P or another index. Want to have some fun with numbers? Plug in some normal returns into a compound interest calculator, then do it again with half a point less interest. That is the difference between a mutual fund and an index fund.
Mutual funds have too much money to invest very well. Think about it, you can’t invest more than a few hundred thousand dollars in a stock without driving up the price. If you have a billion dollars to invest, that means you will have to pick dozens of stocks. That means the management must constantly pick stocks and re-evaluate their current holdings. It also means that if any one stock does particularly well, it doesn’t effect the bottom line very much. There are only so many stocks out there for managers to choose from, when they have to pick 50 stocks that means only 10% of the stocks are in their top 5 choices, the other 90% are pretty far down the list. How well do you think their 48th, 49th and 50th choice are going to do?
Mutual funds are too hard to understand. Investors should always follow the axiom “Only invest in what you understand.” It is time consuming enough to evaluate one stock. Can you really expect to understand and evaluate all 50, 100 or 200 stocks in a mutual fund? If you’re going to take the time to understand the stocks in a mutual fund then you might as well just buy the stocks yourself.
Moral of the story: Don’t buy a mutual fund unless its an index fund.
Ryan G. says: Index funds have long been recognized to be attractive investment options because of the principles outlined above. Vanguard is a great option because they have great funds and are generally among the lowest priced index funds available to the general public (Vanguard is a also non-profit company; their goal is to make it easier for investors to direct more of their money to their investments and spend less of their money supporting the company running the fund). This article is not meant to be an endorsement for Vanguard, but for index funds in general. As always, do you research before buying any equities or other investments.
About the author: This is a guest article by Ryan Delany, aka HarvardMarine. Ryan is the author of Semper Finance, an investing blog geared to military members and individuals with a goal of improving their net worth.