This year has gotten off to a slow start, with all major indices off by about 3% in January. But that didn't stop investors from pouring into mutual funds, which saw inflows of about $44.5 billion for that month.
In fact, as of last week, U.S. equity funds and ETFs had experienced their seventh straight week of inflows -- the longest streak since 2004.
Let me tell you why this is an ominous sign for the investing community and how you can avoid making some major mistakes in the decades to come.
Not exactly what you signed up for
You see, managed mutual funds suffer from three specific ailments.
First, they can have insanely high fees. There's always an expense ratio, which charges you a percentage of your investment. But funds will often tack on a "management fee," a "12b-1" fee (which is basically a marketing fee), and sometimes even a "purchase fee" -- the fund charges you every time it purchases a stock! When you add all these fees up, it makes it almost impossible for you to generate enough returns to offset the extreme costs of doing business.
Second, actively managed mutual funds typically have very high turnover. This means that they are constantly buying and selling stocks; every time they do so, they incur a commission fee that is ultimately passed onto you -- again, as a fee. Instead of buying and holding for the long term, managers often feel the pressure to buy turnaround stocks like Ford Motor (NYSE: F) or Sirius XM Radio (Nasdaq: SIRI), and then dump them once they've secured a modest profit.
Third, mutual funds don't always offer you the diversification you think you might be getting. For instance, say you want diversified health-care exposure, so you invest in the Health Care Select Sector SPDR -- but then you learn that 25% of its holdings are concentrated in just two stocks, Johnson & Johnson (NYSE: JNJ) and Pfizer (NYSE: PFE).
And this isn't a one-time fluke: The Materials Select Sector SPDR, which includes Monsanto (NYSE: MON) and Dow Chemical (NYSE: DOW), counts its top three stocks as 30% of its total holdings! That's not exactly the broad diversification you'd hope for.
These three reasons are probably why, historically, 80% of mutual funds underperform the stock market’s return in a typical year. And now it seems as though we’re continuing to flood the market with more and more capital -- not exactly a great sign for investors.
A much better alternative
Investors who actually want to beat the market need to be buying individual stocks. Discount brokerage firms like Charles Schwab have lowered their trading fees so much that investing on your own is now a truly inexpensive option. Investing in stocks on your own means you don't have to put up with all sorts of ambiguous fees, which lowers your costs and ultimately will lead to great returns.
And because you're in charge, you aren't captive to high turnover rates, and you can actually be a buy-and-hold investor. Lastly, it also means you can take charge of diversification, picking and choosing the stocks that you think will give you the best return for the least risk.
But picking stocks can be a daunting task -- that is, unless you know the right places to look.
Where to look
Start by looking for stocks with the following characteristics:
- low price-to-earnings ratios
- historical earnings growth
- potential for future earnings growth
- management you can trust
This will ensure you're buying a stock at a reasonable price and that there's a good chance that company will see its value increase over the long haul.
For example, Hasbro (NYSE: HAS), the toy company that has come up with everything from Monopoly to G.I. Joe, has grown its revenue at an average of 6% a year for the past five years and has an excellent pipeline of products. It has a reasonable P/E ratio of 15.7, and analysts expect it to grow by at least 10% each year for the next five years.
Those were the qualities that attracted our analysts at Motley Fool Stock Advisor, who recently recommended the toy company. If you need help getting started picking your own stocks, or if you're interested in learning more about Hasbro, you can see all the past and present recommendations from David and Tom Gardner (who spearhead Stock Advisor), free for 30 days. Click here for more information.
Fool contributor Jordan DiPietro owns shares of Hasbro. Monsanto and Pfizer are Motley Fool Inside Value selections. Ford Motor, Hasbro, and Charles Schwab are Stock Advisor picks. Johnson & Johnson is an Income Investor recommendation. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Fool owns shares of Hasbro and has a disclosure policy.
