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Here Are 3 Ways Investing in Mutual Funds Can Cost You a Lot

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I’ve been investing through mutual funds for decades now.

It’s not the sexiest way to invest, I know.

It also can have some serious drawbacks if you’re not careful and unlucky. Here are 3 ways it can hurt your results, and what to do about it.

Why Investing in Mutual Funds Is Smart

If you’re like most of us, you’re not an investment pro, and don’t have the time, expertise, experience, and analyst support needed to reliably out-perform the markets investing in individual stocks. That’s where the right mutual fund can help.

These funds are managed by professionals who have years, if not decades, of investment management experience. They’re usually supported by a team of seasoned analysts who research investment opportunities and feed those to the portfolio managers who then decide which ones to buy for the fund.

Investing through a fund also gives you instant diversification at least among stocks, and for some funds across market sectors or even different asset classes.

However, that doesn’t mean that mutual fund investing is free of risks and costs. Here are some of the ones to worry about.

Choosing the Wrong Fund

According to Statista.com, as of 2018 there were 9599 mutual funds in the US, worth over $17.7 trillion. In any given year, as stated by The Balance, most actively managed funds underperform the index of the sector(s) they invest in. Even if a fund outperforms this year, there’s no assurance it will continue that outperformance. In fact, if you routinely invest in the hottest funds based on last year’s numbers, you’ll most likely be buying high and selling low. That’s a good way to lose a lot of money.

Here are 2 ways to mitigate this risk:

  • Invest in no-load low-cost index mutual funds. These funds track specific indexes, and underperform slightly (due to the management fees they charge).
  • Invest in actively managed no-load, low-cost mutual funds that have a long track record of outperforming the market, and where the management team hasn’t changed in a long time.

Paying High Fees

Mutual fund advisors are in business to make money. Yeah, I know, big shock 😊. The way they make that money is by charging management fees. These can be extremely low for index funds (according to Statista these charge on average only 0.08%, or $8 a year per $10,000 invested), higher for the average actively managed fund – 0.76% ($76 a year per $10,000 invested), and really high for some funds (I’ve seen fees of more than 2%, or $200 a year per $10,000 invested).

Actively managed funds also buy and sell investments, incurring trading fees. Some funds may trade so frequently that they effectively turn over their entire portfolio multiple times in a single year. This carries a high cost. Guess who pays for it? Yup, you the investor.

I’ve mentioned “no-load” funds a couple of times above. In mutual fund parlance, “load” refers to marketing costs that investors pay when they invest in the fund, and which are used to bring in new investors. For example, some funds pay over 5% commission to investment advisors who get their clients to invest in the fund. Again, this comes out of your investment dollars.

Research has shown that on average, load funds underperform no-load funds by about the cost of the load. Thus, as an investor, you gain nothing from investing in a load fund (except in that this may cause you to refrain from churning into and out of these funds, which can save you from selling low and buying high).

Here are several ways to minimize this issue:

  • Invest only in no-load funds with low management fees.
  • Invest in index funds.
  • Avoid funds with high investment turnover.

Buying a Large Tax Liability

By law, mutual funds are required to distribute interest income, capital gains, and dividends to their shareholders each year. This can lead to your owing a lot of taxes, even if you lost money!

Here’s how.

Say mutual fund X has had a stellar return over the first 10 months of the year, and is up 50% relative to January 1 of the year. You’re excited about the fund and invest $15,000 on November 1. The market then changes radically, causing fund X to lose 20% between November 2 and December 20, which is when fund X distributes its returns to shareholders.

Say the net asset value (NAV, what mutual fund share price is called) was $10 on January 1. That means it was $15 when you bought in so you got 1000 shares at that price, and $12 when the distributions took place. At that point, you had a loss of $3000. However, since the fund was up 20% for the year, you received that 20% as a distribution (which you could reinvest or spend, as you choose). You now owe taxes on $2000, despite having actually lost $3000!

Here are 4 ways to avoid or at least minimize the impact of such a scenario:

  • Invest in mutual funds through a tax-advantaged account such as a 401(k), IRA, etc.
  • Concentrate your investments early in the year (so you only pay taxes on returns you reaped.
  • Choose mutual funds that are managed in a tax-efficient manner.
  • Invest in exchange-traded funds (ETFs) instead of mutual funds.

Bottom Line

Mutual funds are very useful vehicles to invest in the markets, gain instant diversification, and have investment professionals manage your money for far less than you’d have to pay if you wanted them to manage your money individually.

However, there are some gotchas that can cost you a lot of money if you don’t know what you’re doing. The above are three such pitfalls, and what to do to avoid or at least minimize their impacts.

Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.

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