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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
If you're looking for the quickest, easiest way to get started in the investing world, mutual funds are definitely the way to go. There's no better way to get exposure to a variety of stocks or bonds in one simple stop. Let's take a closer look to see if mutual fund investing might be right for you.
The workhorse of your portfolio
Mutual funds -- which include actively managed funds, index funds, and exchange-traded funds (ETFs) -- buy shares of stocks or bonds for their portfolio. A typical fund can hold dozens or even hundreds of individual stocks. Then, when you buy a share of a mutual fund or ETF, you get a partial ownership interest in all of the companies the fund owns. And just like that, you now own all those stocks in one easy step. And the best part is, you don't have to keep track of any of them; the portfolio manager, the person in charge of running the fund, is tasked with the job of keeping tabs on all of the stocks, including selling stocks when they hit their price targets or fail to live up to expectations and buying new names into the portfolio.
Mutual funds take a lot of the work out of developing an investment portfolio for beginning investors. While many people may want to invest in the stock market, a great number of them don't have the time or the know-how to track dozens of individual stocks. With funds, you just find a good manager and a good fund and let him or her do all the heavy lifting. After all, why not take advantage of the knowledge and stock-picking prowess of some of the industry's sharpest investing minds?
Just like stocks, mutual funds comes in many flavors, from low-risk index funds that track a well-known benchmark like the S&P 500 to spicier, high-risk funds that invest in super-small micro-cap companies. So while potential risk and reward in fund investing varies greatly depending on which type of fund you buy, in general, buying a mutual fund is less risky than buying shares of a single stock. This is simply because a mutual fund has greater diversification, or exposure to many companies, so even if one stock blows up, it shouldn't affect the rest of the portfolio too much. Of course, the flip side is that mutual funds won't typically double or triple in value in short periods of time the way a share of stock can!
But there are other potential problems with actively managed mutual funds. One of the primary drawbacks is that not all funds will end up doing better than the market. In fact, a great number of them end up lagging the market because of their high fees. While there is no shortage of excellent, low-cost funds out there, you've got to do a little bit of work to weed out the good from the bad.
Finding the best funds
If you're a very cost-conscious investor who doesn't care a whole lot about beating the market, index funds or exchange-traded funds are probably a good choice for you. Instead of having managers pick stocks that they think will outperform, these funds simply track a common market index. In this case, your best bet is to stick to inexpensive funds (probably less than 0.30% in expenses) that invest in wide sections of the market. In other words, buy ETFs that invest in a wide swath of the large-cap market rather than just biotechnology large-cap companies. Getting exposure to more of the stock market means greater diversification, and greater risk reduction for your portfolio.
Actively managed funds require a bit more detective work. Here, the first thing you want to look for is a fund that has a consistent investment process over time, rather than one that has changed its approach over the years. Next, only consider funds that have a manager or management team that has been with the fund for a long time, preferably at least a decade. A fund is only as good as its manager, so you want to see his results over long periods of time. Be sure to only buy funds with reasonable expenses, nothing higher than 1.4% in annual costs. And only after a fund meets all those initial criteria should you look at performance. Here, you want a fund that beats most of its competition, say at least two-thirds of them, over a long-term time period of a decade or more. Look for a fund that has done well in both bull markets like 2003-2007 and in bear markets like 2008. Short-term performance isn't as important -- you want a fund with long-term staying power.
Some prime candidates
One actively managed mutual fund that meets these criteria very well is Dodge & Cox Stock (DODGX). The fund has been around since 1965 and is run by a team of nine managers, two of whom have been working on the fund since the 1980s. Dodge & Cox has utilized the same value-oriented investment process since the fund's inception, throughout many different market environments. The fund only charges 0.52% a year, far less than the average mutual fund. Performance here has been top notch, with the fund posting an 8.2% annualized gain over the past 15 years, better than 96% of all large-cap value funds.
Likewise, Fidelity Contrafund (FCNTX) has been run by manager Will Danoff for more than 20 years, using the same investment process to identify growth-oriented securities like top holdings Apple (Nasdaq: AAPL ) and Google (Nasdaq: GOOG ) . Over the past 15 years, the fund has returned 8.8% on an annualized basis, compared with a 5.9% gain for the S&P 500 Index. That's better than 94% of its large-growth competition. Contrafund has performed well in both bull and bear markets over the past two decades and comes with a 0.92% price tag, still well below average for large-cap growth funds.
Ultimately, mutual funds can find a home in almost any investor's portfolio. They're some of the easiest tools for beginning investors to use to get their portfolio rolling. Whether you prefer passively managed index funds and ETFs or active funds, the diversification benefits of funds are hard to beat. If you're looking for a bit of a helping hand with your investments, mutual funds should be your first stop.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.