That Makes Cents: Which Mutual Funds Are Best?

by Patrick Gleeson, Ph. D., ; Updated December 14, 2017
That Makes Cents: Which Mutual Funds Are Best?

There was a time when if you worked for a corporation you probably had a retirement fund sponsored and at least partly funded by your corporation. Unfortunately, for most Americans, particularly younger Americans, that time has passed. If you've entered the job market more recently, it's up to you to figure out how to invest for your retirement. Here's how to open and fund a retirement account with the best mutual funds.

Begin at the Beginning

Let's start at ground zero: The best place to put your money for retirement is in stocks. Overall, stocks outperform bonds and real estate and have done so for over a hundred years.

But investing in the stock markets sounds a little scary – there's that "I lost everything in the market" problem you've probably heard about. What you may not have heard is why some investors lose everything – instead of investing in the market, they use it as a gambling forum, chasing hot stocks and stock tips. That's probably not a good approach.

If you invest sensibly instead, the odds strongly favor you reaching your retirement goals with about a nine percent annual return on your investment. That's the average market return on the U.S. stock market for over a hundred years. That doesn't mean you'll make nine percent every year. Some years you'll make a lot more – maybe five or six times more – and some years you'll lose money. But you're in this for the long run. It doesn't really matter that you'll have some great years and some bad years. What counts is your cumulative average from now to the day you retire. A very good way to have a great cumulative average return is to minimize risk by investing in widely diversified mutual funds with the lowest management fees. Particularly when you're beginning your investment account, those are the best mutual funds to buy.

Getting Started With Mutual Funds

Begin by setting up a brokerage account. Big online brokerages with low transaction fees like Charles Schwab and TD Ameritrade are good bets. Both firms make signing up as easy as possible. Google the name of the brokerage you've selected and you'll find a lot of easily understood instructions to help you sign up. You'll probably complete the process in under 15 minutes.

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What to Do Next

If the company you work for has an option to automatically deduct a certain amount from your paycheck and send it directly to your brokerage account, use it! If not, you'll have to discipline yourself and get into the habit of sending money to your investment account out of each paycheck.

Many financial advisors recommend sending a specific percentage of your earnings – often 10 percent – and if that works for you, great. But the important thing is that however much you put in each month, make the process as automatic as possible by sending the same amount from each paycheck.

Make Your Account an IRA Account

OK, now you've got your brokerage account and you've figured out a way to get money into that account on a regular basis. Early on in the process, you'll also want to identify your account as a retirement account – usually an IRA (most everyone assumes this stands for Individual Retirement Account, which is close enough, although the IRS calls it an Individual Retirement Arrangement – go figure). Usually you can specify the IRA account type when you first sign up.

You want an IRA acount for a couple of reasons. For one thing, you can start an IRA account with a smaller initial investment than for non-retirement accounts.

Another reason is that when you put your money in a traditional IRA, you don't have to pay taxes on it until you retire. With more money flowing into the account every paycheck, your money grows faster. By the time you retire, the IRA will be worth a lot more than an individual non-retirement account funded with post-tax money.

If, for example, if you're in a 15 percent bracket, the post-tax contribution on $400 will be $340. With an IRA, you get to put in the full $400. If you're making the contributions monthly until you retire – for example, in 40 years – the difference between the two accounts may surprise you. Assuming your account gets the average nine percent compounded annual return, 40 years from now the individual non-retirement account's worth about $1.3 million. But the IRA's worth over 1.5 million! That's why you want your money in an IRA.

Mutual Funds

OK, your IRA's set up and you've started contributing monthly, but what do you invest in?

For many reasons, the best place to start (and not a bad place to stay for that matter) is with one or more mutual funds. A mutual fund is a fund run by its own management company (not your broker) that invests in stocks on behalf of its shareholders.

So, why not just buy the stocks yourself? The problem is – and it's a big one – is that one of the best ways to lose a lot of money fast is to invest in just a few related hot stocks (all tech stocks, for example), betting that this small group of stocks will outperform the market, meaning their stock prices will keep on rising faster than the market itself.

That can happen. But when each of those hot tech stocks crashes in unison – which happened in 2002 – then where are you?

Here's the deal: Stocks that "outperform the market" are, by that very fact volatile stocks. Volatility is a two-way street. Stocks that shoot up faster than the market can also shoot down just as fast. And similar stocks – tech, in this example – tend to be highly correlated, meaning they rise and fall in value together. Holding just a few individual stocks, particularly if they're all in the same market sector, is really putting all your eggs in one basket.

At some later point in your investment career – after a few years when you've got a solid portfolio of mutual funds – it's fine to buy a few hot stocks. But when you're starting out, it's best to put your money in highly diversified mutual funds.

Highly Diversified Index Funds

The many different kinds and categories of mutual funds and Exchange Traded Funds (which work pretty much the same way as mutual funds) will make your head spin. There are literally dozens, even hundreds of different funds for each category. The first thing you'll want to do is narrow down the number of funds you're looking at to a manageable number. For various reasons, highly diversified funds – funds with portfolios holding many different kinds of stocks – are a good place to start

One kind of fund that enjoys a high degree of diversification is called an Index Fund. Indexed ETFs work the same way.

Index funds invest in all the funds in a particular market segment. For instance, there are popular Index Funds that invest in every fund in the Dow Jones Industrial Average. That's good, but that's still only 30 different companies. To start investing, you might be better off investing in a Index Fund that buys all 500 stocks in the S&P 500. Your first fund doesn't have to be an S&P 5oo Index Fund, but it should be a fund with a broad index - one that covers a lot of different companies, ideally in many different market segments. The shorthand way of describing such a fund is that it's a broad, highly diversified index fund

Index funds buy the same proportion of a stock for its portfolio that this stock has in the market segment it's indexing. In the Dow's thirty stocks, for example, the largest holding is Boeing, which accounts for about eight percent of the total value of the Dow. So a fund indexed to the Dow would put about eight percent of its money into Boeing.

Why Indexing Is a Good Idea

When you buy a diversified index fund, you're not trying to beat the market (a surprisingly bad idea); you're trying to match the cumulative average return of all the stocks in the index. Since by definition a broad, diversified index fund guarantees that your return closely approximates the return on investment (ROI) of the entire market, your investment in that fund will enjoy a similar return. With a highly diversified broad Index Fund, chances are good that over the long run you'll have a return close to the historical market average of nine percent per year. That return is compounded – meaning that if you put in $100 to start, at the end of the first year you'll have $109; $ 118.09 at the end of the second year you'll have $118.18 at the end of the third and so on. A nine percent compounded annual return doubles in value every eight years even if you don't put in another cent. Since you're making regular contributions, your investment account will grow even faster.

Some Index Funds Are Better Than Others

If you were going to buy a single fund to start your portfolio, an S&P 500 index fund is one great choice. But you'll notice that there are over 50 S&P 500 Index Funds available. Which ones are the ones to buy?

This is a great question, or more accurately, a question with a great answer, which is: S&P 500 index funds with the lowest management fees are the best ones to buy.

Why Are Fees Important?

Extensive studies by qualified economists show that over time funds with the lowest fees generate the highest returns. Surprisingly, a lot of investors don't know this. Instead, they'll buy the fund with the best return on investment over some period of time, usually one year, three years or five years because "they're outperforming the market."

Books have been written on what's wrong with this approach. But to cut to the chase, a Standard and Poors study concludes that if you track those mutual funds with the best track records in a given year – S&P tracked those funds with top 25 percent returns – and compared them with the 25 percent that performed the worst that same year_, _ten years down the line you couldn't tell for sure which group was best in that first year and which group was the worst.

There are several things to be learned from this study:

  • Hot funds don't stay hot forever.
  • The "best performing funds" in one year can be the worst in another.
  • Brokers who sell their clients funds that "outperform the market" are basically selling them a lot of hooey.
  • That over the long run, the best performing fund of any kind – whether an index fund, growth fund, value fund, tech fund or any other kind of fund – is the fund in that given class with the lowest management fees.

Index Funds with Low Management Fees

Historically, one investment management company, Vanguard, has led the way in reducing management fees for mutual funds and ETFs. In recent years,Vanguard's advantage has narrowed and occasionally even been eclipsed as other fund companies have lowered their fees to compete. In 2017, Schwab announced they were offering funds that intentionally undercut Vanguard's low fees. Schwab's S&P 500 Index Fund currently has an annual expense ratio of 0.03, which is extraordinarily low. Vanguard's 500 ETF is almost as low with an annual expense ratio of 0.05. Either of these funds would be an excellent investment for your IRA account.

About the Author

I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.

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