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SECTION 5: FUNDS
72: Why mutual funds are great. No other vehicle offers as much diversification and convenience. They also provide a low-cost way for individual investors to gain access to professional management. And with no-load mutual funds, you can make regular deposits or dollar-cost average without additional fees -- something you can't typically do with stocks.
73: Hot funds will go cold, but costs are forever. As a mutual fund investor, you pay your share of the fund's costs -- management fees and other operating expenses, including the unreported costs of trading. All told, the typical fund's costs probably run between 2 percent and 2.5 percent annually, only some of which shows up in the expense ratio. That's why so many funds underperform. Not even Lance Armstrong could zoom ahead with that kind of cement block dragging behind his back tire. You can shed some of that handicap by sticking with index funds and other low-cost choices.
74: How to choose a mutual fund. Picking a fund because it topped the performance charts for a few months or a year is an almost sure way to lose money. Instead, focus on more predictable factors. Among the signs of a quality outfit: a low expense ratio, managers who invest their own money in the funds, and the willingness of the firm to close funds to new investors to keep them from growing too large. And you don't want a fund that has a new manager every few years. Past performance counts, but focus on long-term returns and compare the fund against others that follow a similar strategy.
75: Index funds beat most other funds over time. Don't want to spend a lot of time choosing funds? Stick with index funds, which simply mirror a market benchmark like the S&P 500. What's so great about that? Thanks partly to ultralow costs, over the past five years, Vanguard's 500 Index fund has beaten 33 percent of domestic-stock funds. Over 10 years, 72 percent. Over 20 years, 84 percent.
76-80: Five great places to invest with as little as $500. You don't need a lot of money to get started investing in funds. These no-loads all have low minimum initial investments.
Artisan International $1,000 800-344-1770
Excelsior Value & Restructuring 500 800-446-1012
FAM Value 500 800-932-3271
Gateway 1,000 800-354-6339
Selected American 1,000 800-243-1575
81: Why you pay a sales charge for a mutual fund. If you buy funds using a broker or other professional who gives you advice, you'll pay a sales load; that's how your broker is compensated.
82: How loads work. Mutual funds often have different share classes, each with its own fee structure. The typical load fund structure: When you buy A shares you pay a one-time sales charge, known as a front-end load; B shares have a back-end load -- you pay when you sell shares; C shares carry both a front-end and back-end load. A shares tend to have lower annual expenses than B or C shares, and they're usually the best deal.
83: The smart way to use sector funds. If you have a diversified portfolio, you already own plenty of tech, health-care and financial stocks. Buying a sector fund that specializes in these areas can throw your portfolio out of balance. Instead, put a small portion of your equity stake -- say, 5 percent to 10 percent -- into a sector like real estate that doesn't tend to move with the rest of the market.
84: Mutual funds: the next generation. Exchange-traded funds, or ETFs, are baskets of securities that trade on an exchange like a stock. They have lower annual expenses than most mutual funds, and they're more tax efficient. You pay commissions to buy and sell them, though, so they're not suited to dollar-cost averaging. There are dozens of ETFs. Among the most popular: SPDRs (Spiders) track the S&P 500; Diamonds, the Dow; iShares, foreign and domestic indexes and individual sectors; Vipers, Vanguard index funds; and Cubes, the Nasdaq 100 index.
85: Owning 10 mutual funds doesn't mean you're diversified. Diversifying means adding variety. But many funds, especially those that invest in large stocks, have surprisingly similar holdings. Go to morningstar.com and use the X-Ray tool to see if your funds' portfolios overlap.
86: How Morningstar's star system works. The number of stars is based on a fund's long-term performance and how much risk it took. Five stars is the highest rating. Morningstar says that the stars should not be considered a prediction of how the fund will perform in the future.
Three model fund portfolios for typical investors
87: You can cover the markets with as few as two index funds.
CORE STOCK: Vanguard Total Stock Market Index 60 percent
CORE BOND: Vanguard Total Bond Market Index 40 percent
88: Using actively managed funds, you can fine-tune, adding a small stock fund and an international fund.
CORE STOCK: Clipper 35 percent
SECONDARY STOCK: C & B Mid Cap Value 15 percent
CORE INTERNATIONAL: Causeway Intl. Value 10 percent
CORE BOND: Dodge & Cox Income 40 percent
89: For further diversification, add a real estate fund and a high-yield bond fund.
CORE STOCK: Oakmark 35 percent
SECONDARY STOCK: Fidelity Small Cap Stock 10 percent
CORE INTERNATIONAL: Julius Bear Intl. Equity 10 percent
SPICAL STOCK: Cohen & Steers Realty 5 percent
CORE BOND: Fremont Bond 30 percent
SPECIAL BOND: Northeast Investors trust 10 percent
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