Mutual Funds For Dummies. Eric Tyson

Mutual Funds For Dummies

that, this section reviews some key investing concepts that you continually come across as an investor.

Getting a return: Why you invest

An investment’s return measures how much the investment has grown (or shrunk, as the case may be). Return figures are usually quoted as a rate or percentage that measures how much the investment’s value has changed over a specified period of time. So if an investment has a five-year annualized return of 8 percent, then every year for the past five years that investment, on average, has gotten 8 percent bigger than it was the year before.

So what kind of returns can you expect from different kinds of investments? I say can because we’re looking at history, and history is a record of the past. Using history to predict the future, especially the near future, is dangerous. History won’t exactly repeat itself, not even in the same fashion and not necessarily when you expect it to.

Over the past century, ownership investments like stocks and real estate returned around 8 to 9 percent per year, handily beating lending investments such as bonds (around 5 percent) and savings accounts (roughly 4 percent) in the investment performance race. Inflation averaged around 3 percent per year, so savings account and bond returns barely kept up with increases in the cost of living. Factoring in the taxes that you must pay on your investment earnings, the returns on lending investments actually didn’t keep up with these increases. (For comparisons of various funds’ returns, see Chapter 17.)

Measuring risks: Investment volatility

If you read the previous section, you know you should put all your money in stocks and real estate, right? The returns sure look great. So what’s the catch?

The greater an investment’s potential return, the greater (generally) its risk, particularly in the short term. But the main drawback to ownership investments is volatility (the size of the fluctuations in the value of an investment). Last century, for example, stocks declined by more than 10 percent in a year approximately once every five years. Drops in stock prices of more than 20 percent occurred about once every ten years (see Figure 1-1). Thus, to earn those generous long-term stock market returns of about 9 percent per year, you had to tolerate volatility and be able to hold onto the investment for a number of years to wait out sharp, short-term declines. That’s why you absolutely should not put all your money in the stock market.

In Figure 1-2, you see bonds that have had fewer years in which they’ve provided rates of return that were as tremendously negative or positive as stocks. Bonds are less volatile, but, as I discuss in the preceding section, on average you earn a lower rate of return.

FIGURE 1-1: Historic probability of different U.S. stock returns.

FIGURE 1-2: Historic probability of different U.S. bond market returns.

Some types of bonds have higher yields than others, but nothing is free, either. A bond generally pays you a higher rate of interest as compared with other bonds when it has

Lower credit quality, which compensates for the higher risk of default and the higher likelihood that you’ll lose your investment.

Longer-term maturity, which compensates for the risk that you’ll be unhappy with the bond’s interest rate if interest rates move up.

Callability, which retains an organization’s or company’s right to buy back (pay off) the issued bonds before the bonds mature.

Companies like to be able to pay off early if they’ve found a cheaper way to borrow the money. Early payback is a risk to bondholders because they may get their investment money returned to them when interest rates have dropped.

Diversifying: A smart way to reduce risk

Diversification is one of the most powerful investment concepts. It requires you to place your money in different investments with returns that aren’t completely correlated. Now for the plain-English translation: With your money in different places, when one of your investments is down in value, the odds are good that at least one other is up.

To decrease the odds that all your investments will get clobbered at the same time, put your money in different types or classes of investments. The different kinds of investments include money market funds, bonds, stocks, real estate, and precious metals. You can further diversify your investments by investing in international as well as domestic markets.

You should also diversify within a given class of investments. For example, with stocks, diversify by investing in different types of stocks that perform well under various economic conditions. For this reason, mutual funds and exchange-traded funds, which are diversified portfolios of securities, are highly useful investment vehicles. You buy into funds, which in turn pools your money with that of many others to invest in a vast array of stocks or bonds.

You can look at the benefits of diversification in two ways:

Diversification reduces the volatility in the value of your whole portfolio. In other words, when you diversify, you can achieve the same rate of return that a single investment can provide but with reduced fluctuations in value.

Diversification allows you to obtain a higher rate of return for a given level of risk.

Chapter 2

Fund Pros and Cons

IN THIS CHAPTER

Seeing how mutual funds and exchange-traded funds work

Discovering reasons to choose funds

Considering the drawbacks

I’m not sure where the mutual in mutual funds comes from; perhaps it’s so named because the best funds allow many people of differing economic means to mutually invest their money for:

Easy diversification

Access to professional money managers

Specific investment objectives in particular types of securities

No matter where the word came from, mutual funds and exchange-traded funds, like any other investment, have their strengths and weaknesses that you need to know about before you invest your

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