CHAPTER 18
How You Could Make Your Million Owning Mutual Funds

What Are Mutual Funds?

A mutual fund is a diversified portfolio of stocks managed by a professional investment company, usually for a small management fee. Investors purchase shares in the fund itself and make or lose money based on the combined profits and losses of the stocks within the fund.

When you purchase a mutual fund, what you’re buying is long-term professional management to make decisions for you in the stock market. You should probably handle a mutual fund differently from the way you handle individual stocks.

A stock may decline and never come back in price. That’s why you must always have a loss-cutting policy. In contrast, a well-selected, diversified domestic growth-stock fund run by an established management organization will, in time, always recover from the steep corrections that naturally occur during bear markets. The reason mutual funds come back is that they are broadly diversified and generally participate in each recovery cycle in the U.S. economy.

How to Become a Millionaire the Easy Way

Mutual funds are outstanding investment vehicles if you learn how to use them correctly. However, many investors don’t understand how to manage them to their advantage.

The first thing to understand is that the big money in mutual funds is made by owning them through several business cycles (market ups and downs). This means 15, 20, or 25 years or longer. Sitting tight for that long requires enormous patience and confidence. It’s like real estate. If you buy a house, then get nervous and sell out after only three or four years, you may not make anything. It takes time for your property to appreciate.

Here’s how I believe you, as a shrewd fund investor, should plan and invest. Pick a diversified domestic growth fund that performed in the top quartile of all mutual funds over the last three or five years. It will probably have an average annual rate of return of about 15% or 20%. The fund should also have outperformed many other domestic growth-stock funds in the latest 12 months. You’ll want to consult a reliable source for this information. Many investment-related magazines survey fund performance every quarter. Your stockbroker or library should have special fund performance rating services so you can get an unbiased review of the fund you’re interested in purchasing.

Investor’s Business Daily rates mutual funds based on their 36-month performance records (on a scale from A+ to E) and also provides other performance percentages based on different time periods. Focus your research on mutual funds with an A+, A, or A– performance rating in IBD. During a bear market, growth fund ratings will be somewhat lower. The fund you pick does not have to be in the top three or four in performance each year to give you an excellent profit over 15 years or more.

You should also reinvest your dividends and capital gains distributions (profits derived from a mutual fund’s sales of stocks and bonds) to benefit from compounding over the years.

The Magic of Compounding

The way to make a fortune in mutual funds is through compounding. Compounding occurs when your earnings themselves (the performance gains plus any dividends and reinvested capital) generate more earnings, allowing you to put ever-greater sums to work. The more time that goes by, the more powerful compounding becomes.

In order to get the most benefit from compounding, you’ll need a carefully selected growth-stock fund, and you’ll need to stick with it over time. For example, if you purchase $10,000 of a diversified domestic growth-stock fund that averages about 15% a year over a period of 35 years, here is an approximation of what the result might be, compliments of the magic of compounding:

First five years: $10,000 might become $20,000

Next five years: $20,000 might become $40,000

Next five years: $40,000 might become $80,000

Next five years: $80,000 might become $160,000

Next five years: $160,000 might become $320,000

Next five years: $320,000 might become $640,000

Next five years: $640,000 might become $1.28 million!

Suppose you also added $2,000 each year and let it compound as well. Your total could possibly then come to more than $3 million!

Now, how much more do you think you’d have if you also bought a little extra during every bear market of 6 to 12 months while the fund was temporarily down 30% or more from its peak?

Nothing’s ever guaranteed in this world, and, yes, there are always taxes. However, this example is representative of how the better growth funds have performed over the last 50 years, and what could happen to you if you plan and invest in mutual funds correctly. Over any 20- to 25-year period, your growth fund should average two to three times what a savings account would return. It’s definitely possible.

When Is the Best Time to Buy a Fund?

Anytime is the best time. You’ll never know what the perfect time is, and waiting will usually result in your paying a higher price. You should focus on getting started and becoming regular and relentless about building capital that can compound over the years.

How Many Funds Should You Own?

As time passes, you may discover you’d like to develop an additional long-term program. If so, do it. In 15 years, you might have hefty amounts in two or even three funds. However, don’t overdo it. There’s no reason to diversify broadly in mutual funds. Individuals with multimillion-dollar portfolios could spread out somewhat further, allowing them to place sums into a more diverse group of funds. To do this correctly, you need to make some attempt to own funds with different management styles. For example, you could divvy up your money among a value-type growth fund, an aggressive growth fund, a mid- to large-cap growth fund, a small-cap fund, and so on. Many fund organizations, including Fidelity, Franklin Templeton, American Century, and others, offer funds with varied objectives. In most cases, you have the right to switch to any other fund in the family at a nominal transfer fee. These families offer you added flexibility of making prudent changes years later if you want an income or balanced fund.

Are Monthly Investment Plans for You?

Programs that automatically withhold money from your paycheck are usually sound if you deposit that money in a carefully selected, diversified domestic growth-stock fund. However, it’s best to also make a larger initial purchase that will get you on the road to serious compounding all that much quicker.

Don’t Let the Market Diminish Your Long-Term Resolve

Bear markets can last from six months to, in some rare cases, two or three years. If you’re going to be a successful long-term investor in mutual funds, you’ll need the courage and perspective to live through many discouraging bear markets. Have the vision to build yourself a great long-term growth program, and stick to it. Each time the economy goes into a recession, and the newspapers and TV are saying how terrible things are, consider adding to your fund when it’s 30% or more off its peak. You might go so far as to borrow a little money to buy more if you feel a bear market has ended. If you’re patient, the price should be up nicely in two or three years.

Growth funds that invest in more aggressive stocks should go up more than the general market in bull phases, but they will also decline more in bear markets. Don’t be alarmed. Instead, try to look ahead several years. Daylight follows darkness.

You might think that buying mutual funds during periods like the Great Depression would be a bad idea because it would take you 30 years to break even. However, on an inflation-adjusted basis, had investors bought at the exact top of 1929, they would have broken even in just 14 years, based on the performance of the S&P 500 and the DJIA. Had these investors bought at the top of the market in 1973, they would have broken even in just 11 years. If, in addition, they had dollar cost averaged throughout these bad periods (meaning they had purchased additional shares as the price went down, lowering their overall cost per share), they would have broken even in half the time.

The 1973 drop in the Nasdaq from the peak of 137 would have been recovered in 3½ years, and as of February 2009, the Nasdaq average had recovered from 137 to 1,300. Even during the two worst market periods in history, growth funds did bounce back, and they did so in less time than you’d expect. In other words, if you took the absolutely worst period of the twentieth century, the Great Depression, and you bought at the top of the market, then dollar cost averaged down, at worst, it would have taken you seven years to break even, and over the following 21 years, you would have seen your investment increase approximately eight times. This is compelling evidence that dollar cost averaging into mutual funds and holding them for the long haul could be smart investing.

Some people may find this confusing, since we have said that investors should never dollar cost average down in stocks. The difference is that a stock can go to zero, while a domestic, widely diversified, professionally managed mutual fund will find its way back when the market eventually gets better, often tracking near the performance of benchmarks like the S&P 500 and the Dow Jones Industrial Average.

The super-big gains from mutual funds come from compounding over a span of many years. Funds should be an investment for as long as you live.

They say diamonds are forever. Well, so are your funds. So buy right and sit tight!

Should You Buy Open- or Closed-End Funds?

“Open-end” funds continually issue new shares when people want to buy them, and they are the most common type. Shares are normally redeemable at net asset value whenever the present holders wish to sell.

A “closed-end” fund issues a fixed number of shares. Generally, these shares are not redeemable at the shareholder’s option. Redemption takes place through secondary market transactions. Most closed-end fund shares are listed for trading on exchanges.

Better long-term opportunities are found in open-end funds. Closed-end funds are subject to the whims and discounts below book value of the auction marketplace.

Should You Buy Load or No-Load Funds?

The fund you choose can be a “load” fund, where a sales commission is charged, or a “no-load” fund. Many people prefer no-loads. If you buy a fund with a sales charge, discounts are offered based on the amount you invest. Some funds have back-end loads (sales commissions that are charged when withdrawals are made, designed to discourage withdrawals) that you may also want to take into consideration when evaluating a fund for purchase. In any event, the commission on a fund is much less than the markup you pay to buy insurance, a new car, a suit of clothes, or your groceries. You may also be able to sign a letter of intent to purchase a specified amount of the fund, which may allow a lower sales charge to apply to any future purchases made over the following 13 months.

Few people have been successful in trading no-load growth funds aggressively on a timing basis, using moving average lines and services that specialize in fund switching. Most investors shouldn’t try to trade no-load funds because it’s easy to make mistakes in the timing of buy and sell points. Again, get aboard a mutual fund for the long term.

Should You Buy Income Funds?

If you need income, you may find it more advantageous not to buy an income fund. Instead, you should select the best fund available and set up a withdrawal plan equal to 1½% per quarter, or 6% per year. Part of the withdrawal will come from dividend income received and part from your capital. If you selected the fund correctly, it should generate enough growth over the years to more than offset annual withdrawals of 6% of your total investment.

Should You Buy Sector or Index Funds?

Steer away from funds that concentrate in only one industry or area. The problem with these funds is that sectors go into and out of favor all the time. Therefore, if you buy a sector fund, you will probably suffer severe losses when that sector is out of favor or a bear market hits, unless you decide to sell it if and when you have a worthwhile gain. Most investors don’t sell and could end up losing money, which is why I recommend not purchasing sector funds. If you’re going to make a million in mutual funds, your fund’s investments should be diversified for the long term. Sector funds are generally not a long-term investment.

If you are conservative, it may be OK for you to pick an index fund, where the fund’s portfolio closely matches that of a given index, like the S&P 500. Index funds have outperformed many actively managed funds over the long run. I tend to prefer growth funds.

Should You Buy Bond or Balanced Funds?

I also don’t think most people should invest in bond or balanced funds. Stock funds generally outperform bond funds, and when you combine the two, you’re ultimately just watering down your results. However, someone who is in retirement might want to consider a balanced fund if less volatility is desired.

Should You Buy Global or International Funds?

These funds might provide some diversification, but limit the percentage of your total fund investment in this higher-risk sector to 10% or 15%. International funds can, after a period of good performance, suffer years of laggard results, and investing in foreign governments creates added risk. Historically, Europe and Japan have underperformed the U.S. market.

The Size Problem of Large Funds

Asset size is a problem for many funds. If a fund has billions of dollars in assets, it will be more difficult for the fund manager to buy and sell large positions in a stock. Thus, the fund will be less flexible in retreating from the market or in acquiring meaningful positions in smaller, better-performing stocks. For this reason, I’d avoid most of the largest mutual funds. If you have one of the larger funds that’s done well over the years, and it is still doing reasonably well despite having grown large, you should probably sit tight. Remember, the big money is always made over the long haul. Fidelity Contrafund, run by Will Danoff, has been the best-managed large fund for a number of years.

Management Fees and Turnover Rates

Some investors spend a lot of time evaluating a fund’s management fees and portfolio turnover rates, but in most cases, such nitpicking isn’t necessary.

In my experience, some of the best-performing growth funds have higher turnover rates. (A portfolio turnover rate is the ratio of the dollar value of buys and sells during a year to the dollar value of the fund’s total assets.) Average turnover topped 350% in the Fidelity Magellan Fund during its three biggest performance years. CGM Capital Development Fund, managed by Ken Heebner, was the top-performing fund from 1989 to 1994. In two of those years, 1990 and 1991, it had turnover rates of 272% and 226%, respectively. And Heebner’s superior performance even later in CGM Focus fund was concentrated in 20 stocks that were actively managed.

You can’t be successful and on top of the market without making any trades. Good fund managers will sell a stock when they think it’s overvalued, when they are worried about the overall market or a specific group, or when they find another, more attractive stock to purchase. That’s what you hire a professional to do. Also, the institutional commission rates that funds pay are extremely low—only a few cents per share of stock bought or sold. So don’t be overly concerned about turnover rates. It’s the fund’s overall performance over several years that is key.

The Five Most Common Mistakes Mutual Fund Investors Make

1. Failing to sit tight for at least 15 years or more

2. Worrying about a fund’s management fee, its turnover rate, or the dividends it pays or buying new funds or last year’s #1 fund

3. Being affected by news in the market when you’re supposed to be investing for the long term

4. Selling out during bad markets or switching funds too often

5. Being impatient and losing confidence too soon

Other Common Mistakes

Typical investors in mutual funds tend to buy the best-performing fund after it’s had a big year. What they don’t realize is that history virtually dictates that in the next year or two, that fund will probably show much slower results. If the economy goes into a recession, the results could be poorer still. Such conditions are usually enough to scare off those with less conviction and those who want to get rich quick.

Some investors switch (usually at the wrong time) to another fund that someone convinces them is much safer or that has a “hotter” recent performance record. Switching may be OK if you have a really bad fund or if you’re in the wrong type of fund, but too much switching quickly destroys what must be a long-term commitment to the benefits of compounding.

America’s long-term future has always been a shrewd investment. The U.S. stock market has been growing since 1790, and the country will continue to grow in the future, in spite of wars, panics, and deep recessions. Investing in mutual funds—the right way—is one way to benefit from America’s growth and to secure your and your family’s long-term, 20-plus-year financial future.

How to Use IBD to Buy ETFs

To be perfectly honest, I’m not a big fan of exchange-traded funds because I think you can make more money by focusing on the market leaders. But because ETFs had become so wildly popular with not only individual investors but also asset managers, we started covering ETFs in February 2006.

ETFs are basically mutual funds that trade like a stock, but offer transparency, tax efficiency, and lower expenses.

While mutual funds set their prices or net asset value (NAV) once a day, the prices of ETFs jump up and down throughout the day, just like a stock price. Anything you can do with a stock, you can do with an ETF, such as selling short and trading options.

ETFs are more tax-friendly than mutual funds because of what happens under the hood. When market makers need to create or redeem shares, they round up the underlying stocks and trade them with the provider for new ETF shares. They do the opposite to redeem ETF shares for the underlying stocks. No money changes hands because the shares are traded in-kind.

Unlike mutual funds, ETFs are not affected by shareholder redemptions. If too many investors pull money out of mutual funds, fund managers may be forced to sell the stocks they hold to raise cash, thereby incurring a taxable event. ETFs keep trading to a minimum, so there are few taxable gains.

ETFs charge management fees of anywhere from 0.10% to 0.95%. That’s considerably smaller than those of mutual funds, which charge 1.02% on average.¹

However, with a good mutual fund, you’re getting a top-notch manager who makes investment decisions for you. An ETF requires that you pull the buy and sell triggers.

Don’t kid yourself that the diversification in an ETF will somehow protect you. Take the SPDR Financial Sector (XLF). In the banking meltdown in 2008, this ETF plunged 57%.

The SPDR (SPY), which tracks the S&P 500, was the first U.S.-listed ETF. It started trading on the Amex in 1993. The Nasdaq 100, known today as PowerShares QQQQ Trust (QQQQ), and the Diamonds Trust (DIA), which tracks the Dow Jones Industrial Average, were both launched in the late 1990s.

Today, there are ETFs tracking not only benchmark indexes, but also bonds, commodities, currencies, derivatives, carbon credits, investment strategies such as low-P/E stocks, and more. In 2007 and 2008, ETF launches were what IPOs were to the Internet bubble. Providers floated ETFs based on esoteric indexes that diced sectors into ridiculous slices such as Wal-Mart suppliers, spin-offs, companies with patents, those that don’t do any business with Sudan, and those engaged in “sinful” activities like gambling, alcohol, and tobacco.

ETFs have changed the way many people trade, although not always for the better. They offer average investors access to foreign markets such as India, which limits foreign investors. They also let you trade commodities and currencies without having to open a separate futures or foreign exchange trading account. And the advent of inverse ETFs lets those with accounts that prohibit shorting to put on a short position by buying long.

Since February 2004, ETFs have accounted for from 25% to as much as 44% of the monthly trading volume on the NYSE Arca.

Top-Down Selection

IBD lists the 350 ETFs with the highest 50-day average volume and categorizes them by U.S. Stock Indexes, Sector/Industry, Global, Bonds/Fixed Income, and Commodities and Currencies. Within each category, they’re listed by our proprietary Relative Strength rating in descending order. Ranking ETFs by RS highlights the leaders within each category and helps you compare them. The tables also list year-to-date return, Accumulation/Distribution rating, dividend yields, the prior day’s closing price, the price change, and the change in volume versus the daily average.

Aside from reading IBD’s ETF coverage, monitor the “Winners & Losers” table on the exchange-traded funds page. Every day it lists the leaders and laggards over a given time period, which is rotated daily:

Monday: one-week percentage change

Tuesday: one-month percentage change

Wednesday: three-month percentage change

Thursday: six-month percentage change

Friday: twelve-month percentage change

Owning Both Mutual Funds and a Stock Portfolio

Many smart investors own both funds and stocks. If you have learned how to manage your stock portfolio with skill using all the CAN SLIM buy and sell rules, you should be showing improved, superior results during each bull market and moving out of most stocks in the early phase of each bear market.