Mutual Funds For Dummies E-Book

Eric Tyson

• Herausgeber: John Wiley & Sons
• Kategorie: Ratgeber
• Sprache: Englisch

Seitenzahl: 667

Veröffentlichungsjahr: 2016

Beschreibung

Position your portfolio for growth with one of America's bestselling mutual fund books Are you looking for a trusted resource to help you add mutual funds to your investment strategy? With straightforward advice and a plethora of specific, up-to-date mutual fund recommendations, personal finance expert Eric Tyson helps you avoid fund-investing pitfalls and maximize your chances of success. Newly revised and updated, Mutual Funds For Dummies quickly and easily helps you pick the best funds, assemble and maintain your portfolio, and evaluate your funds' performance. In no time, it gets you up and running on exchange-traded funds, tax laws affecting investments in funds, how to evaluate different fund-investing strategies, and much more. * Plan and implement a successful investment strategy that includes mutual funds * Avoid fund-investing pitfalls * Find the best-managed funds that match your financial goals * Select among mutual funds, exchange-traded funds, and other investing options Complemented with sample fund portfolios and updated forms that show you exactly how to accomplish your financial goals, this is your trusted resource for planning and implementing a successful investment strategy that includes mutual funds.

Leseprobe

Praise for Eric Tyson’s Mutual Funds For Dummies®

“Eric Tyson gets it. Mutual Funds For Dummies cuts through the clutter that clouds personal finance for millions of Americans. This is a must-read for the savvy investor and novice alike.”

—Gerry Dick, Indianapolis Economic Development Corp., and Host, Indiana Business This Week, WRTV/WFYI-TV, Indianapolis

“I was clueless and intimidated by the terminology and information that I need to know about investing into mutual funds. This book has given me confidence as well as a sturdy foundation to begin investing.”

—Clifford Record, Colt’s Neck, New Jersey

“You don’t have to be a novice to like Mutual Funds For Dummies… . Author Eric Tyson clearly has a mastery of his subject. He knows mutual funds, and he knows how to explain them in simple English… . It’s hard to imagine a more accessible sourcebook.”

—Kiplinger’s Personal Finance Magazine

“Mutual Funds For Dummies … is an excellent source for not only the novice investor but also for someone looking to enhance their understanding of one of the fastest growing investment tools.”

—Northwest Arkansas Times

“I handle my mother’s money and my own family’s, so it is very important that I make all the right moves and decisions. I didn’t have any confidence until I studied Eric Tyson’s books.”

—Lisa Patten, Lake Junaluska, NC

“… Injects common sense into the dizzying world of mutual funds.”

—Oakland Tribune, CA

“I liked how easy the book is to read. I understand more now about mutual funds than I did before I read the book — it’s excellent.”

—Dennis Pipper, Lansing, MI

“A book that should help investors be smarter … readable, comprehensive… . Tyson’s encyclopedic book is chock-full of useful examples and advice for both new and experienced investors… .”

—Christian Science Monitor

“Mutual Funds For Dummies … brought me up to speed financially.”

—Riccardo Heald, New York, NY

“Comprehensive, well-organized information in an easy-to-read format.”

—Dianne L. Zimmerman, Rockville, MD

“Mutual Funds For Dummies gives good common sense advice about putting your financial house in order.”

—John B. Fout, MBA

“I wish my finance teachers in college had been this interesting and informative.”

—Lori Buono, reader

“Eric Tyson is far and away the best writer, most readable author, and most honest and intelligent voice in America today in the areas of personal finance and mutual fund investing.”

—David Diaman, Enrolled Agent

“Never have I been as impressed with the advice and insight offered by a columnist, as I have been by Eric Tyson! Finally, there is someone in print cogently and lucidly speaking financial truth and common sense.”

—Kenneth S. Imbriale, Staten Island, NY

“Accurate, easy-to-read, and humorous; ‘teaches’ the reader rather than preaching at the reader!”

—Victoria L. Simmons, High Point, NC

Mutual Funds For Dummies® 7th Edition

Published by:John Wiley & Sons, Inc.111 River StreetHoboken, NJ 07030-5774www.wiley.com

Copyright © 2016 by Eric Tyson

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Control Number: 2016935558

ISBN 978-1-119-21551-6 (pbk); ISBN 978-1-119-21553-0 (ebk); ISBN 978-1-119-21554-7 (ebk)

Mutual Funds For Dummies®

To view this book's Cheat Sheet, simply go to www.dummies.com and search for “Mutual Funds For Dummies Cheat Sheet” in the Search box.

Table of Contents

Cover

Introduction

What’s New in This Edition

How This Book Is Different

Foolish Assumptions

Icons Used in This Book

Beyond the Book

Where to Go from Here

Part 1: Getting Started with Funds

Chapter 1: Making More Money, Taking Less Risk

Introducing Mutual Funds and Exchange-Traded Funds

Making Sense of Investments

Surveying the Major Investment Options

Reviewing Important Investing Concepts

Chapter 2: Fund Pros and Cons

Getting a Grip on Funds

Opting for Mutual Funds

Addressing the Drawbacks

Chapter 3: Funding Your Financial Plans

The Story of Justine and Max

Lining Up Your Ducks Before You Invest

Reaching Your Goals with Funds

Part 2: Evaluating Alternatives to Funds

Chapter 4: Selecting Your Own Stocks and Bonds

Deciding to Choose Your Own Stocks and Bonds

Picking Your Own Stocks and Bonds

Chapter 5: Exchange-Traded Funds and Other Fund Lookalikes

Understanding Exchange-Traded Funds

Mimicking Closed-End Funds: Unit Investment Trusts

Customizing Your Own Funds Online

Chapter 6: Hedge Funds and Other Managed Alternatives

Hedge Funds: Extremes of Costs and Risks

Wrap (Or Managed) Accounts: Hefty Fees

Private Money Managers: One-on-One

Robo-Advisors: Automated Investment

Part 3: Separating the Best from the Rest

Chapter 7: Finding the Best Funds

Evaluating Gain-Eating Costs

Weighing Performance and Risk

Recognizing Manager Expertise

Chapter 8: Using Fund Publications

Reading Prospectuses — the Important Stuff, Anyway

Reviewing Annual Reports

Investigating the Statement of Additional Information (SAI)

Chapter 9: Buying Funds from the Best Firms

Finding the Best Buys

Discount Brokers: Mutual Fund Supermarkets

Places to Pass By

Hiring an Adviser: The Good, Bad, and Ugly

Part 4: Crafting Your Fund Portfolio

Chapter 10: Perfecting a Fund Portfolio

Asset Allocation: An Investment Recipe

Taxes: It’s What You Keep That Matters

Fund-Investing Strategies

Putting Your Plans into Action

Chapter 11: Money Market Funds: Beating the Bank

Money Market Funds 101

Choosing a Great Money Market Fund

Finding the Recommended Funds

Chapter 12: Bond Funds: When Boring Is Best

Understanding Bonds

Sizing Up a Bond Fund’s Personality

Investing in Bond Funds

Eyeing Recommended Bond Funds

Exploring Alternatives to Bond Funds

Chapter 13: Stock Funds: Meeting Your Longer Term Needs

The Stock Market Grows Your Money

Using Funds to Invest in Stocks

The Best Stock Funds

Chapter 14: Specialty Funds: One of a Kind

Sector Funds: Should You or Shouldn’t You Invest in Them?

Landlording Made Easy: Real Estate Investment Trust (REIT) Funds

Profiting from What Everyone Needs: Utility Funds

Arming for Armageddon: Precious Metals Funds

Commodity Funds

Hedging: Market Neutral (Long-Short) Funds

Matching Morals to Investments: Socially Responsible Funds

Chapter 15: Working It Out: Sample Portfolios

Getting Started

Changing Goals and Starting Over

Dealing with a Mountain of Moola

Getting Unstuck …

Chapter 16: Applications, Transfers, and Other Useful Forms

Taking the Nonretirement Account Route

Preparing for Leisure: Retirement Accounts

Investing on Autopilot

Finding Help for an Overwhelmed Brain

Part 5: Keeping Current and Informed

Chapter 17: Evaluating Your Funds and Adjusting Your Portfolio

Deciphering Your Fund Statement

Interpreting Discount Brokerage Firm Statements

Assessing Your Funds’ Returns

Deciding Whether to Sell, Hold, or Buy More

Tweaking and Rebalancing Your Portfolio

Chapter 18: The Taxing Side of Mutual Funds

Mutual Fund Distributions Form: 1099-DIV

When You Sell Your Fund Shares

Retirement Fund Withdrawals and Form 1099-R

Chapter 19: Common Fund Problems and How to Fix Them

Playing the Telephone Game

TroubleShooting Bungled Transactions

Specifying Funds to Buy at Discount Brokers

Making Deposits in a Flash

Verifying Receipt of Deposits

Transferring Money Quickly

Losing Checks and Application Papers in the Mail

Changing Options after Opening Your Account

Making Sense of Your Statements and Profits

Changing Addresses

Finding Funds You Forgot to Move

Untangling Account Transfer Snags

Eliminating Marketing Solicitations

Digging Out from under the Statements

Getting Older Account Statements

Chapter 20: Information Sources: Fund Ratings and Forecasters

Entering Cyberspace: What the Internet Is Good For

Understanding Online Perils

Avoiding the Bad Stuff

Getting In on the Good Stuff

Part 6: The Part of Tens

Chapter 21: Ten Common Fund-Investing Mistakes and How to Avoid Them

Lacking an Overall Plan

Failing to Examine Sales Charges and Expenses

Chasing Past Performance

Ignoring Tax Issues

Getting Duped by “Advisers”

Falling Prey to the Collection Syndrome

Trying to Time the Market’s Movements

Following Prognosticators’ Predictions

Being Swayed by Major News Events

Comparing Your Funds Unfairly

Chapter 22: Ten Fund-Investing Fears to Conquer

Investing with Little Money

Investing in Uninsured Funds

Rising Interest Rates

Missing High Returns from Stocks

Waiting to Get a Handle on the Economy

Buying the Best-Performing Funds

Waiting for an Ideal Buying Opportunity

Obsessing Over Your Funds

Thinking You’ve Made a Bad Decision

Lacking in Performance

Chapter 23: Ten Tips for Hiring a Financial Adviser

Communicator or Obfuscator?

Financial Planner or Money Manager?

Market Timing and Active Management?

Who’s in Control?

Fees: What’s Your Advice Going to Cost?

How Do You Make Investing Decisions?

What’s Your Track Record?

What Are Your Qualifications and Training?

What Are Your References?

Do You Carry Liability Insurance?

Appendix: Recommended Fund Companies and Discount Brokers

About the Author

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End User License Agreement

Guide

Cover

Table of Contents

Begin Reading

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Introduction

Whether you’re a regular reader of investing books or this is your first, Mutual Funds For Dummies, 7th Edition, which is completely revised and updated, provides practical and profitable techniques of fund investing that you can put to work now and for many years to come.

Funds aren’t literally for dummies — in fact, they’re a wise investment choice for people from all walks of life. Mutual funds are investment companies that combine your money with that from many other people to create a large pool of assets that can be invested in stocks, bonds, or other securities. This book also extensively covers exchange-traded funds, which are like mutual funds except that they trade on a stock exchange when the financial markets are open. Because your assets are part of a much larger whole, the best funds enable you to invest in securities that give you low-cost access to leading professional money managers.

With the best money managers investing your nest egg in top-flight investments that match your financial goals, you can spend your time doing the activities in life that you enjoy and are best at. Funds should improve your investment returns as well as your social life!

I practice what I preach. All my investments that I’ve devoted to securities (stocks and bonds) are invested through funds. Why? For the simple reason that I’m confident the best fund managers that I recommend in this book can do a superior job (higher returns, less cost) than I can by researching and selecting individual stocks and bonds on my own.

I’ve enjoyed successfully investing in funds for more than 30 years. As a financial counselor, writer, and lecturer, I’ve helped investors make informed investing decisions with mutual funds as part of comprehensive personal financial management. So I know the questions and challenges that you face when you invest in funds. I wrote this book to answer your fund-investing questions in plain English.

What’s New in This Edition

Life and the investment world change. Although the essence of what makes mutual funds worthy of your investment dollars hasn’t changed since the last edition of this book was published several years ago, the fund industry has certainly seen new developments. In this newly updated seventh edition, here are the major issues:

Alternatives to mutual funds — growth of exchange-traded funds, shake-out in hedge funds, researching your own stocks and bonds, and creating your own fund, private money managers, closed-end funds, and so on

Opportunities and pitfalls investing in funds online with expanded and updated coverage of robo-advisors, websites, and software

New tax laws and their impact on smart fund-investing strategies

Updates to the funds and resources that I recommend

How This Book Is Different

Many investment books confuse folks. They present you with some newfangled system that you never figure out how to use without the help of mathematicians and a Nobel laureate as your personal tutors. Books that bewilder more than enlighten may be intentional because the author may have another agenda: to get you to turn your money over to him to manage or to sell you his pricey newsletter(s). Writers with an agenda may imply — and sometimes say — that you really can’t invest well, at least not without what they’re selling.

Going another route, too many investment books glorify rather than advise. They place on a pedestal the elite few who, during decidedly brief periods in the history of the world and financial markets, managed to beat the market averages by a few percentage points or so per year. Many of these books (and their publishers) suggest that reading them shows you the strategies that led Superstar Money Manager of the Moment to the superlative performance that the book glorifies. “He did it his way; now you can, too,” trumpets the marketing material. Not so. Reading a book about what made LeBron James a phenomenal basketball player or Shakespeare a great playwright won’t help you shoot a basketball or versify like these famous folks. By the same token, you can’t discover from a book the way to become the next Wall Street investment wizard.

Mutual Funds For Dummies, 7th Edition, helps you avoid fund-investing pitfalls and maximizes your chances for success. When you want to buy or sell a fund, your decision needs to fit your overall financial objectives and individual situation. Fund investors make many mistakes in this regard. For example, they invest in funds that don’t fit their tax situation.

This book also covers pesky issues completely ignored by other fund books. For novice fund investors, simply finding and completing the correct application in the blizzard of forms that fund companies offer can be a challenge. And if you invest in funds outside of tax-sheltered retirement accounts, you’re greeted by the inevitable headache from figuring out how to report distributions at tax time. This book puts you on the right path to avoid these problems.

The truth is, investing isn’t all that difficult — and funds are the great equalizer. There’s absolutely no reason, except perhaps a lack of time and effort on your part, why you can’t successfully invest in mutual funds and exchange-traded funds. In fact, if you understand some basic concepts and find out how to avoid major mistakes that occur for some fairly obvious reasons, you can be even more successful than most so-called investment professionals.

Foolish Assumptions

Whenever an author sits down to write a book, he has to make some assumptions about his audience, and I’ve made a few that may apply to you:

You’re looking for sensible investments.

You’ve done some research (or perhaps thought about doing some) on mutual funds and found the thousands of fund choices to be a bit daunting.

Your investment portfolio contains or has contained funds, and you’re looking for up-to-date information on how changes in the economy and financial markets can affect the decisions you make.

If one or more of these descriptions rings true, you’re in the right place. Mutual funds are a huge business, and they can be confusing. Today, thousands of mutual funds account for more than $15 trillion under management, and exchange-traded funds hold another $2 trillion. Although the basic principle behind funds sounds simple enough — pooled money from many individuals that’s invested in stocks, bonds, or other securities — you have to understand the different types of investments, such as stocks and bonds, and the way they work.

Unfortunately, you have too many individual funds from which to choose — hundreds of fund companies, brokerage firms, insurers, banks, and so on are selling thousands of funds. Even experienced investors suffer from information overload. Luckily for you, I present short lists of great funds that meet different needs.

And because no investment, not even one of the better funds, is free of flaws and shortcomings, I explain how to avoid the worst funds — and the numerous mediocre ones — that clutter the investment landscape. I also help you understand when investing in funds may not be appropriate for you and what your best options may be.

Icons Used in This Book

Throughout this book, you can find friendly and useful icons that enhance your reading pleasure and flag special types of information. So when you meet one of these margin-hugging doodads, consider the following:

This icon points out something that can save you time, headaches, money, or all the above!

The warning icon helps steer you away from mistakes and boo-boos that others have made when investing in funds. Something here could cost you big bucks if you don’t devote your attention to these icons.

This icon denotes my favorite mutual funds and exchange-traded funds.

Eminently skippable stuff here, but if you don’t read it, you may not seem as astute at the next cocktail party when fund trivia games begin. Neat but nonessential stuff — read at your leisure.

I’ve told you as much as I can, but you may need or want to check it out more on your own before you make a move.

This icon designates something important that I want you to make sure you don’t forget when you’re making your own fund-investing decisions!

Beyond the Book

In addition to what you’re reading right now, this product also comes with a free access-anywhere Cheat Sheet that can help you think about the role of fund investing in your personal and financial life. To get this Cheat Sheet, simply go to www.dummies.com and search for “Mutual Funds For Dummies Cheat Sheet” in the Search box.

Where to Go from Here

You don’t need to read this book cover to cover. But if you’re a beginner or you want to fully immerse yourself in the world of fund investing, go for it! However, you may have some specific questions today, and you’ll want some other information tomorrow. No problem there, either. Mutual Funds For Dummies, 7th Edition, is well organized and easier to use than other fund-investing books. Use the table of contents or the index to speed your way toward what you need to know and get on with your life.

Part 1

Getting Started with Funds

IN THIS PART …

Understand investment options, risks, rewards, and diversification.

Discover the pros and cons of mutual and exchange-traded funds.

Get your financial house in order before investing in funds.

Chapter 1

Making More Money, Taking Less Risk

IN THIS CHAPTER

Defining mutual funds and exchange-traded funds

Understanding investments

Weighing your options

Seeing the big picture: Returns, risks, and risk reduction

In my years of work as a financial adviser and a columnist answering many readers’ questions, I’ve seen the same, avoidable mistakes being made over and over. Often, these investing mistakes occurred for one simple reason: a lack of investment understanding. People didn’t know what their investing options were and why particular options were inferior or superior to others.

By reading this book, you can prevent yourself from making investment mistakes. And you can take advantage of an excellent investment vehicle: mutual funds — the best of which offer you diversification, which reduces your risks, and low-cost access to highly diversified portfolios and professional money managers, who can boost your returns with less risk. Mutual funds and exchange-traded funds can fit nicely in the context of your overall financial plans and goals. This chapter gives you an investment overview so you can see how mutual funds and exchange-traded funds fit into the overall investment world.

Introducing Mutual Funds and Exchange-Traded Funds

If you already understand stocks and bonds, their risks and potential returns, and the benefits of diversification, terrific. You can skip this chapter. Most people, however, don’t really comprehend investment basics, which is one of the major reasons people make investment mistakes in the first place.

After you understand the specific types of securities (stocks, bonds, and so on) that funds can invest in, you’ve mastered one of the important building blocks to understanding mutual funds. A mutual fund is a vehicle that holds other investments: When you invest in a mutual fund, you’re contributing to a big pool of money that a mutual fund manager uses to buy other investments, such as stocks, bonds, and/or other assets that meet the fund’s investment objectives.

Exchange-traded funds (ETFs) are a very close relative of mutual funds and differ from them in one particular way. ETFs trade like stocks on a stock exchange and thus can be bought or sold during the trading day when the financial markets are open. (In Chapter 2, I explain one exception to this rule. A type of mutual fund, known as a closed-end fund, trades on a stock exchange during the trading day and has a fixed number of shares outstanding.)

Differences in investment objectives are how funds broadly categorize themselves, like the way an automaker labels a car a sedan or a sport utility vehicle. This label helps you, the buyer, have a general picture of the product even before you see the specifics. On the dealer’s lot, the salespeople take for granted that you know what sedan and sport utility vehicle mean. But what if the salesperson asks you whether you want a Pegasus or a Stegosaurus? If you don’t know what those names mean, how can you decide?

Fund terms, such as municipal bond fund or small-cap stock fund, are thrown around casually. Fact is, thanks to our spending-oriented culture, the average American knows car models better than types of funds! In this chapter (and in Chapter 2), I explain the investment and fund terms and concepts that many writers assume you already know (or perhaps that they don’t understand well enough themselves to explain to you). But don’t take the plunge into funds until you determine your overall financial needs and goals.

Making Sense of Investments

Your eyes can perceive dozens of different colors, and hundreds, if not thousands, of shades in between. In fact, you can see so many colors that you can easily forget what you discovered back in your early school days — that all colors are based on some combination of the three primary colors: red, blue, and yellow. Well, believe it or not, the world of investments is even simpler than that. The seemingly infinite number of investments out there is based on just two primary kinds of investments: lending investments and ownership investments.

Lending investments: Interest on your money

Lending is a type of investment in which the lender charges the borrower a fee (generally known as interest) until the original loan (typically known as the principal) gets paid back. Familiar lending investments include bank certificates of deposit (CDs), United States (U.S.) Treasury bills, and bonds issued by corporations, such as Chipotle. In each case, you’re lending your money to an organization — the bank, the federal government, or a company — that pays you an agreed-upon rate of interest. You’re also promised that your principal (the original amount that you loaned) will be returned to you in full on a specific date.

The best thing that can happen with a lending investment is that you’re paid all the interest in addition to your original investment, as promised. Although getting your original investment back with the promised interest won’t make you rich, this result isn’t bad, given that the investment landscape is littered with the carcasses of failed investments that return you nothing — including lunch money loans that you never see repaid!

Lending investments have several drawbacks:

You may not get everything you were promised.

Under extenuating circumstances, promises get broken. When a company goes bankrupt (remember Bear Stearns, Enron, Lehman, WorldCom, and so on), for example, you can lose all or part of your original investment (from purchased bonds).

You get what you were promised, but because of the ravages of inflation, your money is simply worth less than you expected it to be worth.

Your money has less purchasing power than you thought it would. Suppose that you put $5,000 into an 18-year lending investment that yielded 4 percent. You planned to use it in 18 years to pay for one year of college. Although a year of college cost $5,000 when you invested the money, college costs rose 8 percent a year; so in 18 years when you needed the money, one year of college cost nearly $20,000. But your investment, yielding just 4 percent, would be worth only around $10,100 — nearly 50 percent short of the cost of college because the cost of college rose faster than did the value of your investment.

You don’t share in the success of the organization to which you lend your money.

If the company doubles or triples in size and profits, the growth is good for the company and its owners. As a bondholder (lender), you’re sure to get your interest and principal back, but you don’t reap any of the rewards. If Bill Gates had approached you many years ago for money to help make computer software, would you rather have loaned him the money or

owned

a piece of the company, Microsoft?

Ownership investments: More potential profit (and risk)

You’re an owner when you purchase an asset, whether a building or part of a multinational corporation, that has the ability to generate earnings or profits. Real estate and stock are common ownership investments.

Ownership investments can generate profits in two ways:

Through the investment’s own cash flow/income:

For example, as the owner of a duplex, you receive rental income from tenants. If you own stock in a corporation, many companies elect to pay out a portion of their annual profits (in the form of a

dividend

).

Through

appreciation

in the value of the investment:

When you own a piece of real estate in an economically vibrant area or you own stock in a growing company, your investment should increase in value over time. If and when you sell the investment, the difference between what you sold it for and what you paid for it is your (pre-tax)

profit.

(The IRS, of course, will eventually expect its share of your investment profits.) This potential for appreciation is the big advantage of being an owner versus a lender.

On the downside, ownership investments may come with extra responsibilities. If the furnace goes out or the plumbing springs a leak, you, as the property owner, are the one who must fix and pay for it while your tenant gets to kick back in his recliner watching football games and guzzling beer. And you’re the one who must pay for insurance to protect yourself against risks, such as fire damage or accidents that occur on your property.

Moreover, where the potential for appreciation exists, the potential for depreciation also exists. Ownership investments can decline in value as we most recently saw in the late 2000s. Real estate markets can slump, stock markets can plummet, and individual companies can go belly up. For this reason, ownership investments tend to be riskier than lending investments.

Surveying the Major Investment Options

When you understand that fundamentally only two kinds of investments — ownership and lending — exist, you can more easily understand how a specific investment works … and whether it’s an attractive choice to help you achieve your specific goals.

Which investment vehicle you choose for a specific goal depends on where you’re going, how fast you want to get there, and what risks you’re willing to take. Here’s an inventory of investment vehicles to choose from, along with my thoughts on which vehicle would be a good choice for your situation.

Savings and money market accounts

You can find savings and money market accounts at banks; money market funds are available through mutual fund companies. All are lending investments based on short-term loans and are about the safest in terms of risk to your investment among the various lending investments around. Relative to the typical long-term returns on growth-oriented investments, such as stocks, the interest rate (also known as the yield) paid on savings and money market accounts is low but doesn’t fluctuate as much over time. (The interest rate on savings and money market accounts generally fluctuates as the level of overall market interest rates changes.)

Bank savings accounts are backed by an independent agency of the federal government through Federal Deposit Insurance Corporation (FDIC) insurance. If the bank goes broke, you still get your money back (up to $250,000 per depositor, per insured bank). Money market funds, however, aren’t insured.

Should you prefer a bank account because your investment (principal) is insured? No. Savings accounts and money market funds have essentially equivalent safety, but money market funds tend to offer higher yields. Chapter 11 provides more background on money market funds.

Bonds

Bonds are the most common lending investment traded on securities markets. Bond funds also account for about 20 to 25 percent of all mutual fund assets and about 15 percent of all exchange-traded funds. When issued, a bond includes a specified maturity date — the date when your principal is repaid. Also specified when a bond is issued is the interest rate, which is typically fixed (meaning it doesn’t change over time).

Bonds, therefore, can fluctuate in value with changes in interest rates. If, for example, you’re holding a bond issued at 5 percent and the market level of interest rates increase to 7 percent for newly issued similar bonds, your bond will decrease in value. Why would anyone want to buy your bond at the price you paid if it yields just 5 percent and she can get a similar bond yielding 7 percent somewhere else? (See Chapter 12 for more information.)

Bonds differ from each other in the following ways:

The type of institution to which you’re lending your money:

Institutions include state and local governments (municipal bonds), the federal government (treasuries), mortgage holders (Government National Mortgage Association, or GNMA), and corporations (corporate bonds). Foreign governments or corporations can also issue bonds. The taxability of the interest paid by a bond is tied to the type of entity issuing the bond. Corporate, mortgage, and foreign government bond interest is fully taxable. Interest on government bonds issued by U.S. entities is usually free of state and/or federal income tax.

The credit quality of the borrower to whom you lend your money:

The probability that a borrower will pay you the interest and return your entire principal on schedule varies from institution to institution. Bonds issued by less-creditworthy institutions tend to pay higher yields to compensate investors for the greater risk that the loan will not be fully repaid.

The length of maturity of the bond:

Short-term bonds mature in a few years, intermediate bonds in around 5 to 10 years, and long-term bonds within 30 years. Longer-term bonds generally pay higher yields, but their value is more sensitive to changes in interest rates.

Stocks

Stocks are the most common ownership investment traded on securities markets. They represent shares of ownership in a company. Companies that sell stock to the general public (called publicly held companies) include aircraft manufacturers, automobile manufacturers, banks, computer software producers, food manufacturers, hotels, Internet companies, mining companies, oil and gas firms, publishers, restaurant chains, supermarkets, wholesalers, and many types of other (legal) businesses!

When you hold stock in a company, you share in the company’s profits in the form of annual dividends (although some companies don’t pay dividends) as well as in an increase (you hope) in the stock price if the company grows and makes increasing profits. That’s what happens when all is going well. The downside is that if the company’s business declines, your stock can plummet or even go to $0 per share.

Besides occupying different industries, companies also vary in size. In the financial press, you often hear companies referred to by their market capitalization, which is the total value of their outstanding stock. This is what the stock market and the investors who participate in it think a company is worth.

You can choose from two very different ways to invest in bonds and stocks. You can purchase individual securities, or you can invest in a portfolio of securities through a mutual fund. I discuss stock funds in Chapter 13 and individual securities (and other alternatives to funds) in Part 2.

Overseas investments

Overseas investment is a potentially misleading category. The types of overseas investment options, such as stocks and bonds and real estate, aren’t fundamentally different from your domestic options. However, overseas investments are often categorized separately because they come with their own set of risks and rewards.

Here are some good reasons to invest overseas:

Diversification:

International securities markets don’t move in lock step with U.S. markets, so adding foreign investments to a domestic portfolio offers you a smoother ride over the long term.

Growth potential:

When you confine your investing to U.S. securities, you’re literally missing a world of opportunities. The majority of investment opportunities are overseas. If you look at the total value of all stocks and bonds outstanding worldwide, the value of U.S. securities is now in the minority. The U.S. isn’t the world — numerous overseas economies are growing faster.

Some people hesitate to invest in overseas securities because they feel that doing so hurts the U.S. economy and contributes to a loss of U.S. jobs. Fair enough. But I have two counterarguments:

If you don’t profit from the growth of economies and companies overseas, someone else will. If money is to be made there, Americans may as well make some of it.

The U.S. already participates in a global economy — making a distinction between U.S. companies and foreign companies is no longer appropriate. Many companies headquartered in the U.S. also have overseas operations. Some U.S. firms derive a large portion of their revenue and profits from their international divisions. Conversely, many firms based overseas also have operations in the U.S. Increasing numbers of companies are worldwide operations.

Dividends and stock price appreciation recognize no national boundaries! You aren’t unpatriotic if you invest globally. Profits from a foreign company are distributed to all stockholders, no matter where they live.

Real estate

Perhaps the most fundamental of ownership investments, real estate has made many people wealthy. Not only does real estate produce consistently good rates of return (averaging around 8 to 9 percent per year) over long investment periods, but you can also purchase it with borrowed money. This leverage helps enhance your rate of return when real estate prices are rising.

As with other ownership investments, the value of real estate depends on the health and performance of the economy, as well as on the specifics of the property that you own:

If the local economy grows and more jobs are being produced at higher wages, real estate should do well.

If companies in the community are laying off people and excess housing is sitting vacant because of previous overbuilding, rents and property values are likely to fall.

For investors who have time, patience, and capital, real estate can make sense as part of an investment portfolio — check out Real Estate Investing For Dummies (Wiley), which I coauthored. If you don’t want the headaches that come with purchasing and maintaining a property, you can buy mutual funds and exchange-traded funds that invest in real estate properties and related companies (see Chapter 14).

Gold, silver, and the like

Whenever bad things happen, especially inflation, credit crises, and international conflicts, some investors seek out gold, silver, and other precious metals. Over the short term, these commodities may produce hefty returns, but their long-term record is more problematic. See Chapter 14 for all the details and how you might diversify your portfolio by using specialty funds investing in this sector.

Annuities

Annuities are investment products with some tax and insurance twists. They behave like savings accounts, except that they should give you slightly higher yields, and insurance companies back them. As with other types of retirement accounts, the money you put into an annuity compounds without taxation until withdrawal. However, unlike most other types of retirement accounts — 401(k)s, SEP-IRAs — an annuity gives you no upfront tax deductions for your contributions.

Annuities also charge relatively high fees. That’s why it makes sense to consider contributing to an annuity after you fully fund the tax-deductible retirement accounts that are available to you. The best annuities available today are distributed by no-load (commission-free) fund companies. For more information about the best annuities and situations for which annuities may be appropriate, be sure to read Chapter 15.

Life insurance

Some insurance agents love to sell cash-value life insurance. That’s because these policies combine life insurance protection with an account that has a cash value — usually known as universal, whole, or variable life policies — and generate big commissions for the agents who sell them.

Cash-value life insurance isn’t a good investment vehicle. First, you should be saving and investing through tax-deductible retirement savings plans, such as 401(k)s, SEP-IRAs, and IRAs. Contributions to a cash-value life insurance plan provide you no upfront tax benefit. Second, you can earn better investment returns through efficiently managed funds that you invest in outside of a life policy.

The only reason to consider cash-value life insurance is that the proceeds paid to your beneficiaries can be free of estate taxes. Especially in light of recent years’ tax law changes, you need to have a substantial estate at your death to benefit from this feature. Married couples can pass along double these estate tax–free amounts (note that states often have lower limits and bypass trusts may be necessary to double these amounts at the state level). And, by giving away money to your heirs while you’re still alive, you can protect even more of your nest egg from the federal estate taxes. (Term life insurance is best for the vast majority of people. Consult the latest edition of my book Personal Finance For Dummies [Wiley], which has all sorts of good stuff on insurance and other important personal finance issues.)

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. What 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 10 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.

© John Wiley & Sons, Inc.

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

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 1-2: 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

Lower credit quality,

which compensates for the higher risk of default and the higher likelihood that you’ll lose your investment.

Longer-term maturity,

which compensates for the risk that you’ll be unhappy with the bond’s interest rate if interest rates move up.

Callability, which retains an organization’s or company’s right to buy back (pay off) the issued bonds before the bonds mature.

Companies like to be able to pay off early if they’ve found a cheaper way to borrow the money. Early payback is a risk to bondholders because they may get their investment money returned to them when interest rates have dropped.

Diversifying: A smart way to reduce risk

Diversification is one of the most powerful investment concepts. It requires you to place your money in different investments with returns that aren’t completely correlated. Now for the plain-English translation: With your money in different places, when one of your investments is down in value, the odds are good that at least one other is up.

To decrease the odds that all your investments will get clobbered at the same time, put your money in different types or classes of investments. The different kinds of investments include money market funds, bonds, stocks, real estate, and precious metals. You can further diversify your investments by investing in international as well as domestic markets.

You should also diversify within a given class of investments. For example, with stocks, diversify by investing in different types of stocks that perform well under various economic conditions. For this reason, mutual funds and exchange-traded funds, which are diversified portfolios of securities, are highly useful investment vehicles. You buy into funds, which in turn pools your money with that of many others to invest in a vast array of stocks or bonds.

You can look at the benefits of diversification in two ways:

Diversification reduces the volatility in the value of your whole portfolio. In other words, when you diversify, you can achieve the same rate of return that a single investment can provide but with reduced fluctuations in value.

Diversification allows you to obtain a higher rate of return for a given level of risk.

Chapter 2

Fund Pros and Cons

IN THIS CHAPTER

Seeing how mutual funds and exchange-traded funds work

Discovering reasons to choose funds

Considering the drawbacks

I’m not sure where the mutual in mutual funds comes from; perhaps it’s so named because the best funds allow many people of differing economic means to mutually invest their money for

Easy diversification

Access to professional money managers

Low investment management costs

No matter where the word came from, mutual funds and exchange-traded funds, like any other investment, have their strengths and weaknesses that you need to know about before you invest your money. This chapter discusses the advantages and disadvantages of funds.

Getting a Grip on Funds

A mutual fund is a collection of investment money pooled from many investors to be invested for a specific objective. When you invest in a fund, you buy shares and become a shareholder of the fund. The fund manager and his team of assistants determine which specific securities (for example, stocks or bonds) they should invest the shareholders’ money in to accomplish the objectives of the fund and keep shareholders happy.

A misconception some investors hold regarding mutual funds is that they invest in stocks and, therefore, are too risky. They don’t, and they’re not. By using funds, you can invest in a whole array of securities, ranging from money market funds to bonds, stocks, and even real estate.

All funds aren’t created equal. Some funds, such as money market funds, carry virtually zero risk that your investment will decline in value. Bond funds that invest in shorter-term bonds don’t generally budge by more than several percentage points per year. And you may be surprised to find out in Chapter 13 that some conservative stock funds aren’t that risky if you can plan on holding them for a decade or more.

Because good funds take most of the hassle out of figuring out which securities to invest in, they’re among the best investment vehicles ever created for the following reasons:

They allow you to

diversify

your investments — that is, invest in many different industries and companies instead of in just one or two. By spreading the risk over a number of different securities representing many different industries and companies, funds lessen your portfolio’s instability and the chances of a large loss.

They enable you to give your money to the best money management firms and managers in the country.

They are the ultimate couch potato investment! However, unlike staying home and watching television or playing video games, investing in funds can pay you big rewards.

What’s really cool about funds is that when you understand them, you realize they can help you meet many different financial goals. Maybe you’re building up an emergency savings stash of three to six months’ living expenses (a prudent idea, by the way). Perhaps you’re saving for a home purchase, retirement, or future educational costs. You may know what you need the money for, but you may not know how to protect the money you have and make it grow.

Don’t feel badly if you haven’t figured out a long-term financial plan or don’t have a goal in mind for the money you’re saving. Many people don’t have their finances organized, which is why I write books like this one! I talk more specifically in Chapter 3 about the kinds of goals funds can help you accomplish.

Financial intermediaries

A mutual fund company is a type of financial intermediary. (Now that’s a mouthful!) Why should you care? Because if you understand what a financial intermediary is and how fund companies stack up to other financial intermediaries, you’ll better understand when funds are appropriate for your investments and when they probably aren’t. A financial intermediary is nothing more than an organization that takes money from people who want to invest and then directs the money to those who need investment capital (another term for money).

Suppose you want to borrow money to invest in your own business. You go to a bank that examines your financial records and agrees to loan you $20,000 at 8 percent interest for five years. The money that the banker is lending you has to come from somewhere, right? Well, the banker got that money from a bunch of people who deposited money with the bank at, say, 2 percent interest. Therefore, the banker acts as a financial intermediary, or middleman — one who receives money from depositors and lends it to borrowers who can use it productively.

Insurance companies do similar things with money. They sell investments, such as annuities (see Chapter 1) and then turn around and lend the money — by investing in bonds, for example — to businesses that need to borrow. (Remember, a bond is nothing more than a company’s promise to repay borrowed money over a specified period of time at a specified interest rate.)

The best mutual fund companies are often the best financial intermediaries for you to invest through because they skim off less (that is, they charge lower management fees) to manage your money and allow you more choice and control over how you invest your money.

Open-end versus closed-end funds

Open end and closed end are general terms that refer to whether a mutual fund company issues an unlimited or a set amount of shares in a particular fund:

Open-end funds:

Open end

simply means the fund issues as many (or as few) shares as investors demand. Open-end funds theoretically have no limit to the number of investors or the amount of money that they hold. You buy and sell shares in such a fund from the fund company.

Closed-end funds:

Closed-end

funds are those where the mutual fund companies decide upfront, before they take on any investors, exactly how many shares they’ll issue. After they issue these shares, the only way you can purchase shares (or more shares) is to buy them from an existing investor through a broker. (This process happens with buying and selling stock and exchange-traded funds, too.)