The Magic of Compounding

The magic of compound interest is simply a combination of time and rate of return. Let us begin by taking a truly long-term look at the financial markets. Complete data tracing the returns of financial assets are available beginning in 1872. I use primarily the Standard & Poor's 500 Composite Stock Price Index (and a predecessor index prior to 1926) as the measure of common stock returns, the long-term (20-year) U.S. government bond as the measure of bond returns, and the 90-day U.S. Treasury bill as the measure of the returns on cash reserves.

During the 1872-1992 period, the annual return on U.S. common stocks averaged +8.8%, the annual return on long-term bonds averaged +4.6%, and the annual return on cash reserves averaged +4.2%. The differences in returns - which may appear small - result in a staggering dispersion in the final value of $1 invested in each asset class on December 31, 1871. The summary figures are in Table 1-1. A mere 0.4 percentage point increase in return, from +4.2% in bills to +4.6% in bonds, increases the final value of the $1 initial investment by more than 70%. A further 4.2 percentage point increase, to 8.8% in stocks, causes the final value increase an additional 115 times. This is the magic of compounding writ large. Figure 1-1 presents the cumulative returns since December 31, 1981, for each of the three basic asset classes.

Buying Mutual Funds

Buying Mutual Funds
As an individual investor, you have many avenues available to you if you want to invest in mutual funds. You can invest through a company-sponsored 401(k) plan, through a personal IRA account or through a standard brokerage account. But regardless of which avenue you choose, you should be aware that mutual funds don’t trade like stocks. You can buy or sell shares of stock anytime during market hours, but you can only buy or sell mutual funds at the end of the day.
Mutual funds only trade at the end of the day because you trade mutual funds based on their net asset value (NAV). To determine the NAV at the end of the trading day, the mutual fund company looks at all of the assets that are in the basket, determines their value and divides that number by the total number of outstanding shares in the fund. As you can imagine, this can be a complicated process and the fund company only wants to go through it once a day once the market closes.
Mutual-fund companies recognize the inflexibility associated with only being able to trade once a day can be difficult. So to offset a portion of this inflexibility, they allow you to purchase fractional share of the mutual fund.
Imagine a mutual fund is trading at $58.50 and you have $100 you want to invest. If fund companies didn’t allow fractional shares, you would be able to buy one share for $58.50, but the rest of your money would have to wait until you could save enough to buy another full-priced share. But because funds do allow fractional trading, you can utilize your entire $100 and own 1.71 shares.
Now that you know how to buy a mutual fund, how do you search and make sure you’re buying a profitable fund?

Expenses and Prospectus

Expenses
Every mutual fund has expenses. Some funds’ expenses are relatively low while other funds’ have extremely high expenses. You should be aware of a fund’s expenses before you invest because those expenses can have a dramatic effect on your investment returns. The three expenses you should always identify are loads, redemption fees and operating expenses.
Loads are fees that can be charged either when you buy a mutual fund (front-end load) or when you sell a mutual fund (back-end load). These loads are usually used to pay a commission to the agent who sold you the fund. By law, front-end loads cannot be higher than 8.5 percent, but most fund companies opt for load lower than the maximum. Some fund companies have even gone so far as to not charge a load (no-load) on their mutual funds.
Redemption fees are stipulations indicating that if you sell your mutual fund before a certain date, you will be charged a fee. Fund companies impose redemption fees to discourage turnover in the fund.
Operating expenses—management fees and 12(b)-1 fees—comprise the operating expense ratio. These fees are charged as a normal part of doing business for the fund. Management fees go to pay the fund manager for his expertise and time. 12(b)-1 fees cover advertising and distribution expenses for the fund.
Now that you know what expenses you have to account for, where can you go to find out what expenses a fund charges?
Prospectus
A mutual fund company outlines everything you could ever want to know about a fund in the fund’s prospectus. A fund’s prospectus is a booklet that will identify and discuss everything from the fund’s objectives and its past performance to a description of the fund manager and the fees associated with the fund. And if there is something you can’t find in the prospectus, the prospectus provides you will all of the contact information so you can get your questions answered.
Unfortunately, most investors never read through their funds’ prospectuses. But if you want to access this tremendous information, Yahoo! Finance offers and incredible tool to help you locate a fund’s prospectus: the Prospectus Finder.
To watch a video outlining how the Prospectus Finder can help you in your mutual-fund investing, click here.
Now that you know virtually everything about a fund thanks to the prospectus, how do you go about buying that fund?

Performance of mutual fund

Performance
Investors like to see not only the rate of return for an individual mutual fund but also how that fund compares to other similar funds. To see the performance of a fund, investors need look no further than the newspaper or some other quote source. To see how a fund compares to other funds, investors can consult either the Morningstar Ratings or the Lipper Ratings.
The SEC requires mutual funds to furnish historical returns for the following time periods so you can easily see how well a fund has been performing:

Year to date

One year

Three years

Five years

10 years

Since Inception

While seeing how a fund has performed in the past is extremely useful, you don’t have a complete picture of how well the fund has done unless you compare it to other similar funds. For this comparison, you will need to utilize rating from either Morningstar or Lipper. Both of these companies compile comparative performance-based information.
Morningstar rates funds using a “star” system—with 5 stars being the highest rating and 1 star being the lowest rating.

5 stars indicates the fund is in the top 10 percent of its Morningstar category.

4 stars indicates the fund is in the next 22.5 percent of its category.

3 stars indicates the fund is in the next 35 percent of its category.

2 stars indicates the fund is in the next 22.5 percent of its category.

1 stars indicates the fund is in the last 10 percent of its category.

Lipper rates funds using a numeric score—with a “1” being the highest rating and a “5” being the lowest rating.
Now that you know how to measure a fund’s performance, what are the expenses that can affect a fund’s overall performance?

Types of Mutual Funds

Types of Mutual Funds
Mutual funds are divided into two categories: closed-end and open-end.
Closed-end funds have a limited number of shares. If you want to purchase a piece of the fund, you have to purchase an existing share.
Open-end funds have an unlimited number of shares. If you want to purchase a piece of the fund, the fund creates a new share and sells it to you. There are significantly more open-end funds than there are closed-end funds.
Now that you know what types of mutual funds are available, how are those mutual funds classified?

Mutual-fund Classification
Mutual funds are classified by various groups and institutions, but Morningstar is the industry standard when it comes to mutual-fund classification. Morningstar has two classification systems: the Morningstar Style BoxTM and Morningstar Categories.
The Morningstar Style BoxTM is a 3×3 grid that categorizes equity-based mutual funds by the style and size of the equities they hold and fixed-income mutual funds by the duration and quality of the fixed-income instruments they hold.
Mutual funds can also be classified according to the following 48 predetermined categories based on the assets held by the fund:
Diversified Emerging Markets
Diversified Foreign
Diversified World
Europe
General Intermediate-Term
General Long-Term
General Short-Term
General Ultrashort-Term
Government Intermediate-Term
Government Long-Term
Government Short-Term
International Hybrid
Japan
Large Blend
Large Growth
Large Value
Latin America
Mid Blend
Mid Growth
Mid Value
Muni California Intermediate-Term
Muni California Long-Term
Muni National Intermediate-Term
Muni National Long-Term
Muni New York Intermediate-Term
Muni New York Long-Term
Muni Short-Term
Muni Single State Intermediate-Term
Muni Single State Long-Term
Pacific/Asia
Pacific/Asia (ex Japan)
Small Blend
Small Growth
Small Value
Specialty Precious Metals
Specialty Communications
Specialty Emerging Markets Bond
Specialty Financial
Specialty Health
Specialty High-Yield
Specialty International Bond
Specialty Multisector
Specialty Natural Resources
Specialty Real Estate
Specialty Technology
Specialty Utilities
U.S. Hybrid
Now that you know how mutual funds are classified, how can you measure a mutual fund’s performance?

Understanding Mutual Funds

Understanding Mutual Funds
Before you can successfully invest in mutual funds, you need to understand what they are and how they work. Let’s take a look at the basics so you can learn what will make a difference in your portfolio’s performance and what won’t. We’ll start from the beginning—what is a mutual fund?
Mutual Fund
A mutual fund, according to the Securities and Exchange Commission (SEC), “is a company that brings together money from many people and invests it in stocks, bonds or other assets.” In other words, a mutual fund is like a basket, and that basket holds assets, like stocks. When you buy a mutual fund, you purchase a piece of the fund, or basket. You do not actually own any of the assets the mutual fund owns.
But while you may not own the assets themselves, they are important because the value of the fund is based on the value of the assets it holds. As the stocks, bonds and so on within the fund increase in value, the fund increases in value. Conversely, as the stocks, bonds and so on within the fund decrease in value, the fund also decreases in value.

Now that you know what a mutual fund is, what are the benefits of mutual funds?
Benefits
Mutual funds offer two key benefits: diversification and professional management.

Diversification means owning many different assets at one time. Mutual funds offer instant diversification because each fund, or basket, owns multiple stocks, bonds and so on. When you buy a piece of the fund, you essentially buy a piece of every asset held by the fund.>

Professional management means that somebody who spends a lot more time analyzing financial markets than you do will be helping you invest your money.

Now that you know what the benefits of mutual funds are, what types of mutual funds are available?