Ready to Get Your Feet Wet in Mutual Funds?
Come on in, the water's fine. If you follow a few investing basics, you won't feel like you're swimming with sharks.
(MONEY Magazine) – Before I bought my first mutual fund a few years back, I called my older brother Mike, who's an investment banker. His advice? Be aggressive. So I picked the first fund I saw that had "aggressive" in its name and set up an automatic investment plan. Then I puffed out my chest and bought myself a drink. I had, I felt, become an investor.
I've learned a few things since then, to be sure, but I still hear the same advice: Since I'm young, I should be adventurous. After all, I have plenty of time to recover if my investments take an initial beating. On the other hand, because I'm young, the amount I have to invest isn't huge, so I don't want to gamble it away. Which leads me to a question that many beginning investors ask: How big a risk can I handle?
See, at its core, what a lot of people mean by "be aggressive" is "put more money in stocks than in lower-risk assets like bonds and money-market funds." What kinds of stocks? Depends on your plans for the money. My wife (our CFO) and I asked ourselves if we'd want to use the cash anytime soon for, say, a trip to Barbados. We decided that sure, we would--but that we wouldn't actually do it. We were in this for the long haul, and that left us with two good options: small-cap funds, which invest in fast-growing but unseasoned companies and tend to do very well in the long run but cause the occasional heart attack in the short term, and large-cap funds, which invest in established firms and deliver less impressive but decent long-term returns with fewer pains along the way.
What You're In For
What exactly do I mean by heart attack? In five of the past 20 years, small-caps have actually had negative returns (a cardiac-arresting -22%, in fact, in 1990), according to stock research company Ibbotson Associates. And if the market tanks when you finally take the plunge into investing, your spirits can be dampened. "Saving up $3,000 is a big deal, and seeing it turn into $1,500 hurts," says Aaron Coates of NexGen, an association of financial planners age 36 and under.
Plus, when big dips happen, the doomsday crowd likes to rub it in. (As one New York Times headline read after the Nasdaq crash in 2000, "Had Enough? Do You Feel Poor Yet?") This is when your resolve will be tested. But this would be exactly the wrong time to unload. Ever heard an investment adviser tell you to "lock in those losses"? Me neither.
How to Endure It
Is there a way to predict how much of a loss you'll be able to endure en route to a big win? No, but there are indicators. Do you have credit-card debt? Would you like to buy a house or have a child in the next five years? Basically, think about whether you'll have any big expenses and, if you will, whether you think you can leave the fund alone without panicking. Keep in mind that in nine months in 2000, while large-caps lost a tolerable 5%, small-caps were down a gut-wrenching 28%. If you think you could withstand that, be aggressive. Even in the past two decades, when small-caps had all those losing years, they still averaged 13% a year overall. That's better than any other asset can say for itself.