Mutual Funds For Dummies. Eric Tyson

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Don’t fall prey to life insurance agents and their sales pitches. You shouldn’t use life insurance as an investment, especially if you haven’t exhausted your ability to contribute to retirement accounts. (Even if you’ve exhausted contributing to retirement accounts, you can do better than cash-value life insurance by choosing tax-friendly funds and/or variable annuities that use mutual funds; see Chapters 11 through 15 for the details.)

      Limited partnerships

      

Avoid limited partnerships (LPs) sold directly through brokers and financial planners. They are inferior investment vehicles. That’s not to say that no one has ever made money on them, but LPs are so burdened with high sales commissions and investment-depleting management fees that you can do better with other vehicles.

      LPs invest in real estate and a variety of businesses. They pitch that you can get in on the ground floor of a new investment opportunity and make big money. Usually, they also tell you that while your investment is growing at 20 percent or more per year, you’ll get handsome dividends of 8 percent or so per year. It sounds too good to be true because it is.

Many of the yields on LPs have turned out to be bogus. In some cases, partnerships propped up their yields by paying back investors’ principal (original investment), without telling them, of course. The other hook with LPs is tax benefits. Those few loopholes that did exist in the tax code for LPs have largely been closed. The other problems with LPs overwhelm any small tax advantage, anyway.

      The investment salesperson who sells LPs stands to earn a commission of up to 10 percent or more. That means that only 90 cents (or less) per dollar that you put into an LP actually gets invested. Each year, LPs typically siphon off 2 percent or more of your money for management and other expenses. Efficient, no-load mutual funds, in contrast, put 100 percent of your capital to work (thanks to no commissions) and charge 1 percent per year or less in operating fees.

      Most LPs have little or no incentive to control costs. In fact, they may have a conflict of interest that leads them to charge more to enrich the managing partners. And, unlike mutual funds and exchange-traded funds, in LPs you can’t vote with your feet. If the partnership is poorly run and expensive, you’re stuck. That’s why LPs are called illiquid — you can’t withdraw your money until the partnership is liquidated, typically seven to ten years after you buy in. (If you want to sell out to a third party in the interim, you have to sell at a huge discount. Don’t bother unless you’re totally desperate for cash.)

      

The only thing limited about an LP is its ability to make you money. If you want to make investments that earn you healthy returns, stick with stocks (using mutual funds), real estate, or your own business.

Reviewing Important Investing Concepts

      If you reviewed the beginning of this chapter, you have the fundamental building blocks of the investing world. Of course, as the title of this book suggests, I focus on a convenient and efficient way to put it all together — mutual funds. But before doing that, this section reviews some key investing concepts that you continually come across as an investor.

      Getting a return: Why you invest

An investment’s return measures how much the investment has grown (or shrunk, as the case may be). Return figures are usually quoted as a rate or percentage that measures how much the investment’s value has changed over a specified period of time. So if an investment has a five-year annualized return of 8 percent, then every year for the past five years that investment, on average, has gotten 8 percent bigger than it was the year before.

      So what kind of returns can you expect from different kinds of investments? I say can because we’re looking at history, and history is a record of the past. Using history to predict the future, especially the near future, is dangerous. History won’t exactly repeat itself, not even in the same fashion and not necessarily when you expect it to.

      

Over the past century, ownership investments like stocks and real estate returned around 8 to 9 percent per year, handily beating lending investments such as bonds (around 5 percent) and savings accounts (roughly 4 percent) in the investment performance race. Inflation averaged around 3 percent per year, so savings account and bond returns barely kept up with increases in the cost of living. Factoring in the taxes that you must pay on your investment earnings, the returns on lending investments actually didn’t keep up with these increases. (For comparisons of various funds’ returns, see Chapter 17.)

      Measuring risks: Investment volatility

      If you read the previous section, you know you should put all your money in stocks and real estate, right? The returns sure look great. So what’s the catch?

The greater an investment’s potential return, the greater (generally) its risk, particularly in the short term. But the main drawback to ownership investments is volatility (the size of the fluctuations in the value of an investment). Last century, for example, stocks declined by more than 10 percent in a year approximately once every five years. Drops in stock prices of more than 20 percent occurred about once every ten years (see Figure 1-1). Thus, to earn those generous long-term stock market returns of about 9 percent per year, you had to tolerate volatility and be able to hold onto the investment for a number of years to wait out sharp, short-term declines. That’s why you absolutely should not put all your money in the stock market.

In Figure 1-2, you see bonds that have had fewer years in which they’ve provided rates of return that were as tremendously negative or positive as stocks. Bonds are less volatile, but, as I discuss in the preceding section, on average you earn a lower rate of return.

      © John Wiley & Sons, Inc.

      FIGURE 1-1: Historic probability of different U.S. stock returns.

      © John Wiley & Sons, Inc.

      FIGURE 1-2: Historic probability of different U.S. bond market returns.

      

Some types of bonds have higher yields than others, but nothing is free, either. A bond generally pays you a higher rate of interest as compared with other bonds when it has

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