Committing to invest money is like finding a good script and deciding to begin production. Although there’s power in making that first decision to begin, the harder parts are still to come. So today we’re going to roll up our sleeves and get a little technical, but in a fun way!
In my last blog post we discussed mutual funds and why these tools are an excellent choice for neophyte investors. I’ve been asked some important questions since that post — the most-common one being: Which fund should I use?
Mutual funds are like a room full of different colored paints, and each hue becomes more attractive under different light. It’s impossible for me to recommend the best fund to magically help your portfolio, but to support your research, here are some fundamental points — each building on the next:
1) Large company funds are safer than small company funds. Having both in your portfolio together is safer yet. The same goes with international funds and sector investments… the more diversified your portfolio is, the less risky it becomes. As you spread more paint on your investing wall, there’s a better chance one is going to work.
2) Every time a fund trades one investment for another, you may pay a tax. Remember in my last post how I explained that a mutual fund is a collection of many different investments? If one isn’t working out, a manager may trade your stock for a juicier one. She also may trade if she believes a stock you own has made tons of money and isn’t going to continue to earn well. If a stock you hold in your fund makes money, you’ll pay a tax on the amount you made. It works like this:
Your mutual fund buys a stock for $10
The fund manager sells the stock for $11
You pay tax on the $1 profit
(It isn’t important for today’s discussion, but this tax is called a capital gain. The next time you hear about Washington lawmakers wrangling over taxes and they talk about reducing or raising the capital gains tax, you’ll know which one they’re talking about.)
A second reason you may also owe tax is if the stock pays a dividend. Think of a dividend as a big “thank you” to current investors. The company takes extra cash they’ve made and splits the pot. It works similarly to a band that gets a portion of the cover charges at a club. The company makes money and splits some with investors.
Although dividends are taxed, the government gives you a special break if you own a stock for more than 60 days. You’ll pay a tax that’s generally lower than the capital gains rate or in many cases pay no tax at all.
What does this mean? Funds with high capital gains taxes will cost you more while those with dividends are less expensive. How do you use this information? Keep reading!
3) Every time a fund trades a stock for another, there are trading costs. If you decided to buy a stock yourself instead of a mutual fund, you’d pay a commission to an online brokerage firm or to a stock broker. Mutual funds also have to pay fees to trade stocks and bonds. Because they place thousands of trades, they get a volume discount. Think of it as the discount you receive at Costco when you buy the mega-pack of paper towels.
4) Funds that trade more often have to pay managers more money. If a fund places lots of trades, managers spend hours researching, tracking, and placing orders to buy or sell. If a fund trades less often, these hourly wages are reduced.
Let’s take a breather. These four points were easier than you thought, weren’t they? And here’s the thing — they lead to a powerful conclusion many investors don’t understand:
5) Funds that trade less often are far less expensive than those that trade frequently. If there are lower tax consequences and lower trading fees, it’s easier for you to make money. Unfortunately, this is why huge-cast shows on Broadway are so rare. It’s difficult for the investor to make money when so many people have to be paid.
Here’s another point that might be surprising:
6) Funds that trade less often outperform those that trade frequently.
A popular type of fund that trades very little is called an index fund. In my next post, I’ll explain why you should think about using these powerful tools and their sisters, exchange-traded funds, in your investment plan.