Mutual funds offer benefits without hassle of stocks

November 1, 2005

Studies have shown that the average fund manager — the highly paid professional who picks out the stocks that a mutual fund will buy — does no better than the average non-professional dart thrower.

Trying to pick individual stocks is simply too much of a hassle for busy professionals and business owners. Of course, that still leaves a wide range of choices. There is all manner of beast when it comes to mutual funds. Here are the major classifications:

Buy only no-load

Any number of studies have shown that the average fund manager - the highly paid professional who picks out the stocks that a mutual fund will buy - does no better than the average non-professional dart thrower. To add insult to injury, the annual management fees charged by these well-dressed mutual fund managers help them to eat your lunch.

Unlike investing in individual stocks, buying a mutual fund cuts you out of the action when it comes time to pick which stocks to buy. But someone has to pick out those stocks, and that job falls to the fund manager.

While there are certainly some superstar managers who manage to deliver extraordinarily high returns for their shareholders, they are as rare as discovering a new stock called Microsoft selling at $5 a share.

Dilution disadvantage

Another disadvantage inherent in mutual funds is called dilution. This is the downside of diversification. Some of the larger funds hold such a huge number of different stocks that even sensational performance by the fund's top holdings still won't make much of a difference in its overall performance.

Finally, there are those deeply buried and often confusing costs. Mutual funds are expert at burying their costs so far underground that you'd need a backhoe to find them.

Contradiction?

Do all of these downers contradict my recommendation that you buy only mutual funds? Absolutely not. What they do is explain why you should buy only index mutual funds.

An index fund matches the shareholdings of a target index, such as the Standard & Poor's 500 Composite Stock Price Index (S&P 500) or the Dow Jones Industrial Average, by buying a balanced proportion of every stock that makes up that index.

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