Forbes Guide to the Markets

Simplicity

For individual investors who have neither the time nor the inclination to actively monitor a stock or bond portfolio, mutual funds have an obvious appeal. Just pick a good fund and let its manager do the work for you. This is perhaps the single most important factor driving the popularity of funds. Some surveys suggest that a majority of investors are skeptical of their own ability as stock pickers and are more inclined to believe that they can identify good fund managers.

On the other hand, some investors are skeptical about the existence of good fund managers or about their own ability to find them. For these investors, index mutual funds offer an approach that lets them participate in the performance of a broad market index such as Standard & Poor’s 500 Index.

Diversification

As the old maxim says, “Don’t put all your eggs in one basket.” Many investors draw the inference that they should not invest all their money in a single stock or bond, but rather spread out their investments among a group of securities. However, it can be difficult for an individual investor to closely monitor more than a handful of individual stocks and still handle his or her other responsibilities. In these circumstances, it can be useful to hire someone who is a full-time participant in the markets. For many people, a mutual fund manager is the most obvious choice. Mutual funds offer varying degrees of diversification, depending on their stated investment objective (discussed in the next chapter) and on how the fund manager(s) translate that objective into a portfolio of securities.

investment objective

What an investor or portfolio manager hopes to accomplish.

Access to New Issues

Fund managers often have much better access to the best initial public offerings of companies and can benefit from an early run-up in the price of shares that may be difficult or impossible for the average investor to get on his or her own. This is an important point for investors who want to participate in such offerings, but it has little relevance for investors who want to be invested only in established company stocks or government bonds.

Diversification is interpreted by investors in a variety of ways. How many stocks should you own? How closely correlated should these stocks be to each other and to the market as a whole? What is the “market as a whole,” anyway? Is it the entire global marketplace or the U.S. market? Is it the entire U.S. market (say, all stocks in the Wilshire 5000) or the S&P 500? A definition of the investment universe and strategic guidelines can help.

Economies of Scale

An equity fund with hundreds of millions of dollars under management is in a far better position than most individuals to conduct the organized research necessary for actively managed portfolios. And when it comes time to execute trades, mutual funds can benefit from the lower per-share trading costs associated with large portfolios. Furthermore, the cost of administrative work (confirming trades, tracking stock dividends, splits, etc.) is spread over a wide number of investors.

Dollar Cost Averaging

Dollar cost averaging (DCA) is a popular investment technique, employed by many mutual fund investors. It can be used to accumulate a large position in a fund (or other security) over a period of time, while reducing risk. Each month, you invest a fixed dollar amount, say $100, in the security. If the price is $10, you purchase 10 shares. If the price goes down to $5 next month, you buy 20 shares. If the price rises to $20, you buy only five shares. Over time, proponents of the strategy argue, it gives you better performance than if you bought all at once. Mutual funds and some direct stock purchase programs offer automatic DCA investment programs; many employers make it even easier by making it part of a payroll deduction program, often coupled with the firm’s retirement savings program.

How good is dollar cost averaging as an investment strategy? This question is harder to answer than it seems. It depends on your criteria, and perhaps on your discipline as an investor. By itself DCA doesn’t improve what market statisticians call your expected return. Expected return is a forecast of average future returns. It is not a return that you should expect in any other sense.

In fact, if the security you are purchasing is increasing in value, you would, on average, be better off putting all of your money in right at the beginning. On the other hand, you may not have a large sum available to invest right now; you may be reinvesting dividends or using payroll deduction to invest periodically. In this case, DCA makes a lot of sense.

What if the security doesn’t increase in value, staying at roughly the same price or declining? If the price stays at roughly the same level, DCA has little obvious effect on return. And if the price is declining, DCA loses less money (again, on average) than would putting all your money in at once. All in all, it appears on first analysis that DCA lowers risk and return in equal amounts, making it suitable for investors who want to lower the riskiness of their investments and don’t mind giving up some return.

Things are not quite so simple, however. There is a psychological, as well as a mathematical, component to investing. The study of how investors really act, taking into account how people think about the market and how they are swayed by emotions, is called behavioral finance. Some studies of actual investor behavior have shown that stocks and funds that individual investors buy underperform the market, while the stocks they sell tend to outperform the market. If this is so, DCA would actually improve the performance of the average investor by taking the investment timing decision out of his or her hands.

Note that some trading costs, such as those due to market impact, timing, and opportunity, are actually higher for larger portfolios. We look at these costs in the next chapter.

Professional Management

The evidence for professional management is mixed. The average mutual fund has frequently underperformed the S&P 500 index, the most widely used benchmark for performance comparison.

This seems like a big negative for professional management until we realize that the professionals are such a large part of the market that, on average, their performance should be about average—and a bit less than average after fees and expenses are taken into account (holding cash also may reduce returns). Finally, most of the time, underperforming the S&P 500 is not the greatest sin, either: That index has, over a long time horizon, delivered impressive growth, even after adjusting for inflation.

Indexing

For those who find low fees attractive, who have a long time horizon, and who don’t mind “average” performance, indexing may be the answer—especially if the recent plunge in equity markets is followed by a period of average (or better) performance.

John Bogle, former chairman of the Vanguard Group of funds, has been the primary proponent of indexing. He has also been one of the leading critics of the mutual fund industry. He argues that index funds are a much better value than actively managed funds. Some, however, go still further, questioning whether even index funds are a good strategy for investors. In the next chapter, we see some of the reasons for this skepticism.