two largest distributors of no-load funds today, exacted sales charges as high as 8.5 percent during the early 1970s. Even today, some mutual funds known as load funds charge you a commission for buying or selling shares in their funds. (See Chapter 7 for the complete story on fund fees.)
Fund diversification minimizes your risk
Diversification is a big attraction for many investors who choose mutual funds and exchange-traded funds. Here’s an example of why, which should also explain what diversification is all about: Suppose you heard that Phenomenal Pharmaceuticals developed a drug that stops cancer cells in their tracks. You run to your phone, contact your brokerage firm, and invest all your savings in shares of Phenomenal stock. Years later, the Food and Drug Administration (FDA) denies the company approval for the drug, and the company goes belly up, taking your entire nest egg with it.
Your money would’ve been much safer in a fund. A fund may buy some shares of a promising but risky company like Phenomenal (if it met the investment objectives of the fund) without exposing investors like you to financial ruin. A fund owns stocks or bonds from dozens of companies, diversifying against the risk of bad news from any single company or sector. So when Phenomenal goes belly up, the fund may barely feel a ripple and that ripple might be offset by the shares of Terrific Telecom, in which the fund has a similarly small stake but which doubled based on its fabulous fiberoptic network.
Diversifying like that on your own would be difficult — and expensive — unless you have a few hundred thousand dollars and a great deal of time to invest. You’d need to invest money in at least 8 to 12 different companies in various industries to ensure that your portfolio could withstand a downturn in one or more of the investments.
Funds typically invest in 25 to 100 securities, or more. Proper diversification increases the probability that the fund receives the highest possible return at the lowest possible risk, given the objectives of the fund.
I’m not suggesting that funds escape without share-price declines during major market downturns. For example, during the early 2000s bear market, many funds declined in value. But again, the investors who were most harmed were those who held individual stocks that, in the worst cases, ended up plummeting to zero as companies went bankrupt, or those investors who loaded up on technology and internet stocks that dropped 80 to 90 percent or more. The same fate befell investors who were overloaded with stock in financial firms like AIG, Bear Stearns, Lehman, and so on that plunged far more than the broad market averages in the late 2000s bear market. During the sharp but brief stock market slide in early 2020 caused by the government-mandated COVID-19 shutdowns, economically sensitive sectors such as airlines, cruise ship companies, and so on suffered the greatest declines a year plus into the pandemic.
Funds undergo regulatory scrutiny
Before a fund can take in money from investors, the fund must go through a comprehensive review process by the Securities and Exchange Commission (SEC). After it offers shares, a fund is required to update its prospectus annually (see Chapter 8) with historical data on the fund’s returns, its operating expenses and other fees, and its rate of trading (turnover) of the fund’s investments.
But know that government regulators aren’t perfect. Conceivably, a fund operator could try to slip through some bogus numbers, but I haven’t heard of this happening and certainly not with the reputable fund companies recommended in this book. And all funds must be audited by independent audit firms who will see their business damaged if they fail to perform their duties accurately. What has happened is that some high-risk and high-fee funds that were destined to perform poorly have been approved. Rest assured that you won’t find any such funds in this book, and you’ll also know how to sidestep them in the future by understanding the principles in this book.
You choose your risk level
Choosing from a huge variety of funds, you can select those that meet your financial goals and take on the kinds of risks that you’re comfortable with. Funds to choose from include
Stock funds: If you want your money to grow over a long period of time (and you can put up with some bad years thrown in with the good), select funds that invest primarily in stocks. (Check out Chapter 13 for the complete story on stock funds.)
Bond funds: If you need current income and don’t want investments that fluctuate as widely in value as stocks do, consider bond funds (see Chapter 12).
Money market funds: If you want to be sure your invested principal doesn’t drop in value because you may need to use your money in the short term, you can choose a money market fund (see Chapter 11).
Most investors choose a combination of these three types of funds to diversify and help meet different financial goals. I get into all that information in the chapters to come.
Fund risk of bankruptcy is nil
Fund companies don’t work like banks and insurance companies, hundreds of which have failed in decades past. (The number of companies going under spiked during the late 2000s recession.) Banks and insurers can fail because their liabilities (the money customers have given them to invest) can exceed their assets (the money they’ve invested or lent). When a big chunk of a bank’s loans goes sour at the same time that its depositors want their money back, the bank fails. That happens because banks have less than 20 cents on deposit for every dollar that depositors place with them. Likewise, if an insurance company makes several poor investments or underestimates the number of claims that insurance policyholders will make, it too can fail.
Such failures can’t happen with a fund company. The situation in which the investors’ demand for withdrawals of their investment exceeds the value of a fund’s assets simply can’t occur because for every dollar of assets that a fund holds for its customers, that fund has a dollar’s worth of redeemable securities.
