Despite their name, savings accounts don’t really save your money. Because the rate of inflation is almost always higher than the rate your money grows in a savings account, you are effectively losing money in any savings account each year.
Mutual funds, however, can offer a much better Return On Investment (ROI) than a savings account. A top performing savings account will grow your money by around 1% a year, a typical mutual fund might grow your money by 5% a year.
To emphasize the importance of a mutual fund’s higher growth potential, consider the difference between 1% savings growth and 5%. Ignoring inflation, at 1% a year, you will double your savings every 70 years, thanks to compound interest.
At 5%, you double your savings every 14 years.
A mutual fund is basically a pool of money a group of investors use to purchase various stocks, currencies, bonds or a mixture thereof. They can be focused on investing in one geographical region, like Asia or Western Canada, and they can also target specific industries or sub-industries, like mining or small-scale banking.
Mutual funds buy and sell assets based on the discretion of the fund manager. Fund managers are typically going to be your Bay Street types who are constantly reviewing individual assets, like a particular company they may buy into and introduce to their fund, or perhaps shares of a company already in the fund that are underpreforming and needs to be cut.
One of the problems I found with my own experience with mutual funds is knowing what exactly your money is being invested in. There are two angles to this:
- Simply knowing where your money is going. You wouldn’t buy a car without knowing as many details about it as possible. Why invest your life savings into a Canadian mid-cap fund without knowing what a mid-cap is, or what specific companies are included?
- There are other reasons for wanting to know what specific companies your money is being invested in: Do you only want to invest in companies that are environmentally friendly? Do you want to invest in Asia, but not China? Maybe only small US-based tech stocks?
Every major financial institution has their own set of mutual funds, and naturally, every financial institution will say they have a mutual fund perfect for you. According to fundlibrary.com, there are around 36,000 mutual funds in Canada. With so many, how are you going to find the right one?
Here are a few things I learned to be aware of when shopping for mutual funds:
- Fees. Those Bay Street-types aren’t cheap, and it’s you, the investor who pays their wages. The biggest complaint against mutual funds is the fees. Many funds have a Management Expense Ratio (MER) of 2%, where every year 2% of your investment will be taken by the fund to pay for itself. The fees include management fees, advertising/marketing fees, legal fees, transaction costs in acquiring assets, etc.
- There are many re-sellers of mutual funds who are paid a commission. And some funds pay better commission to sales people than others. Remember to ask how the person encouraging you to invest in any mutual funds is being paid. Investing in something because a sales person gets a cut is a bad reason.
- Because mutual funds are more risky than savings accounts, you want to avoid putting all your eggs in one basket. If your only mutual fund targets small tech stocks, that is a traditionally risky investment. Be just as prepared to lose a sizable chunk of your savings on bad years as you are to reap the rewards of a risky investment paying off in the good years. If you have mutual funds that invest in very specific things, I would strongly suggest diversifying and looking at a broader range of funds.
- The agony of losing your life savings on a bad bet will always elicit a much stronger emotion than the joy that comes from doubling the value of your life savings.
In comparing mutual funds, you could use a comparison tool such as Van Guards fund comparison page. But I find it difficult making sense out of fund-to-fund comparisons. Instead, I prefer to compare my investments to the bellwether of benchmarks, the S&P 500.
The S&P 500 is an index of the 500 biggest companies in the US. This includes Disney, Apple, Verizon, Citibank, Walmart, Google, etc. The index is calculated by looking at every company’s balance sheets, and regularly ejecting poor preforming companies from the list in favor of up-and-coming companies with excellent balance sheets.
The S&P is also what almost every fund manager uses as their benchmark in determining how well their investment acumen is doing. At an average annual rate of return of 12.65% over the last 40 years, there are virtually no mutual fund managers who have been able to consistently beat the S&P over that period of time.
Which begs the question, can’t you just invest in the S&P 500 index yourself?