A Nice Magic Trick: Mutual Funds

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I don’t like mutual funds. Not because of the excessive fees and not because 95% (or more) underperform the market. I don’t like or invest in mutual funds mainly because I don’t have the temperament for them and I can’t stand their sleight of hand.

No Patience

First some background. My current investment assets are ALL tied up in my 401k account and since I can’t take that money out till I’m 60, it forces me to think for the long term. I also only invest in individual stocks on my 401k plan (If you have this option on your plan, you should really take advantage of it). No mutual funds for me. I have no patience for them.

It may seem contradictory that a supposedly value based investor has no patience, but I find my patience levels for stocks and mutual funds are on completely different scales. When I invest in individual companies I begin to understand the company as a business partner. When I invest in mutual funds, I see only YTD returns and charts.

Common Mistakes

Before I started to learn about investing, I did invest in mutual funds. I figured that a “guaranteed” 10% return would be great. Along with that naivety, I found myself following some common traits.

  1. I looked at the percentage gains and chose funds based on the previous years returns.
  2. I chased after rising funds.
  3. I somehow always seemed to look at “growth” funds.
  4. I switched between funds like a race driver switching lanes.
  5. I figured a 2% expense ratio didn’t affect my investment returns.
  6. I had no idea what I or what the mutual funds were doing and I didn’t do anything about it.

Now 1-5 are all common silly mistakes but the real problem was no. 6. I didn’t know what was going on. Since I didn’t know what I was doing, I was making the first 5 mistakes.
So why wasn’t I doing anything about it? If you read my about me page you would know that I believed I was incapable of investing on my own. But here I am doing it old school style.

Fast Forward with Clarity

I began to notice a trend whenever I went out to a restaurant or even a health supplement shop and asked for a recommendation. Guess where the salesperson always led me? Straight to the highest margin product. Sure they would mention something about another product, but the conversation would quickly focus again on the high margin product.

Witnessing this time after time, a question finally popped into my head. Are brokerage firms or financial advisers trying to sell me something based on margins or commissions without much regard for my financial future? For the majority, the answer is YES. They are all businesses and like all businesses, they need to sell something, sometimes anything, in order to make a buck. This means mutual fund companies have to sell the good the mediocre and even the bad funds. They will pass it all off as good funds of course.

Mutual funds also spend truckloads of cash in advertising and marketing to seduce the first time investors by claiming “performance figures” and diversification, but with so many companies in a mutual fund, there are sure to be bad companies in the mix. The truth is that mutual funds are a product of the financial markets so that companies can make money. Not to make you money.

I’ll end this with a Munger quote.

When you mix raisins and turds, you still have turds – Charlie Munger

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Throw your rubbish in the bin. If it’s too far, throw it from where you are.

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4 responses to “A Nice Magic Trick: Mutual Funds”

  1. You cite all of the reasons mutual funds are not for you. But many of those same missteps can be attributed to any investment.
    The alternative, I suppose is buying individual stocks. How would these six mistakes stack up in such an environment?
    1. I looked at the percentage gains and chose funds based on the previous years returns.
    How many people buy stocks for the exact same reason. Herd mentality is human nature and mutual funds tend to moderate herd sentiment much better than individual traders do.
    2. I chased after rising funds.
    It takes quite a bit of investor acumen to resist selling into a rising market and buy one at the bottom. At least the fund will temper the fall provided you didn’t invest too specifically.
    3. I somehow always seemed to look at “growth” funds.
    Who doesn’t? Value suggests something that would be too staid and conservative although they do provide a nice income pop via dividends in man instances from companies long past their growth prime. Growth is sexier.
    4. I switched between funds like a race driver switching lanes.
    If you do this too often it is because you have fallen prey to the re-balance myth. It is okay to review each quarter, research each year, but if you bought a fund based on its long-term history, the tenure of its manager and less-than-sector-average fees it charges, you can avoid switching with each change of the season.
    5. I figured a 2% expense ratio didn’t affect my investment returns.
    Index… If all else fails, index…
    6. I had no idea what I or what the mutual funds were doing and I didn’t do anything about it.
    As do most stock investors. Market shocks come when investors didn’t see this or that piece of news coming are were caught unaware. And it can happen to the best mutual fund managers as well but I’d be willing to bet that they will be able to spread those losses much better than the individual will.
    For all that is wrong with mutual funds, they are a far better choice than most of us give them credit for.

  2. Jae Jun says:

    Hi Paul,
    Nice observation, and yes, the 6 points can be attributed to any investment.
    Personally, the difference I find between mutual fund investing and stock picking is that with mutual funds, I am betting on the jockey more often than the horse. In a business world where ponies and retired workhorses race against thoroughbreds, I’ve found it easier to do my own research and pick the horses myself rather than rely on the jockey.
    For people that have no interest in investing, finance or business, I recommend they put their money in an index rather than a mutual fund. I believe people invest in mutual funds only because they are 1.led to believe they are incapable of investing on their own since there are “pros” and “experts” who do it daily and are supposed to be better and 2.they have no time or interest in doing it themselves.
    Now to answer all 6 points. After I realised the whole concept of investing, I have never fallen to mistakes 1-5 with my stock picking philosophy. On the other hand, I would probably keep doing the same thing with mutual funds because I don’t know about the companies in the fund or what the outlook is. Not knowing and not understanding will continually tie me to the herd mentality.
    Again, it boils down to one question. Do you know what you are doing? If not, we’ll all end up doing exercises 1-5.

  3. Mark says:

    yeah, index and a few. Most people should be in a mix of low cost index funds and maybe a few stocks.

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