7. What’s a Mutual Fund?
Now that you are aware that cycles in the market will play havoc with your money, you are ready to select mutual funds with your eyes open. Instead of making foolish mistakes that will cripple your savings, you will be able to select certain mutual funds to insulate you from cycles, while giving you a chance to make money whenever and wherever conditions are bestowing wealth.
If you are like many people with a 401(k) plan, you can’t tell one mutual fund from another. Don’t feel bad about this. You are in good company. A few years ago, two well-known professors, Shlomo Benartzi and Richard Thaler, set out to see how people picked mutual funds in their 401(k) plans. They gave a list of funds to employees at the University of California, and their mutual fund choices were abysmal. The employees, like most Americans, didn’t have the slightest idea what they were doing with mutual funds. They didn’t understand what the names of the funds were telling them, so they simply chose every single fund they were offered, even though they should have ignored some of the funds.
You might do that, too—and, if so, you are probably overexposing yourself to the cruelty of cycles and potentially slicing hundreds of thousands of dollars from your future retirement money.
Other mistakes are also common. Typically, when novice investors are losing money in their mutual funds, or making less money than their friends are making with other mutual funds, they surmise that they’ve selected a dud and blown it as an investor.
Neither, however, may be true. You may have a very fine mutual fund that is losing money, or you could be getting richer by the day with a fund that is actually lousy. I know this is counterintuitive: If something looks good, we generally assume that it is good. In investing, the opposite often is true.
Through no fault of its own, your particular fund might simply be temporarily positioned at the top or bottom of a cycle. When that cycle turns, your loser will seem like a phenomenal choice. Instead of destroying your money, it will start making money. Meanwhile, the fund you cherish because it is making you so much money today eventually could look like garbage. Then months later, or even a couple years later, your garbage fund could turn sweet again and your favorite fund could sour.
Your Fund Is Designed for a Purpose
The reason sweet funds often turn into temporary losers is simple: Each mutual fund is constructed for a unique purpose and, therefore, is filled with stocks or bonds that are intended to be strong in certain cycles and weaker in others. This is no small matter. If you don’t know this, you will give some mutual funds more credit than they are due and shun some that deserve to be in your IRA or 401(k) portfolio. About a dozen basic designs exist, and none is inherently good or bad. Each is simply unique.
Think of a bakery. It sells baked goods, but it offers a wide variety intended for different purposes. You can buy muffins, bread, and cake. All are intended to be eaten, but at different points in the day. In other words, they are all valuable but different from each other. Perhaps each is baked to perfection based on a unique recipe. Still, you probably don’t want the cake for breakfast, and that doesn’t mean the baker flopped when baking the cake. Based on where you are in the day’s cycle, the muffin might be best in the morning, the bread at lunch, and the cake after supper.
Just as you want bread, muffins, and cake depending on where you are in the cycle of the day, you want a unique mutual fund for each point in the stock market’s cycle.
And just as you might have all three baked goods in your freezer, awaiting the point in the day when you will want them, you do that with a variety of mutual funds. You keep the variety on hand in your IRA or 401(k) at all times, ready for the parts of the cycle when each will perform best.
Unfortunately, people get tripped up in this process. It seems complex, even though it isn’t. So in effect, if they see that everyone wants cake, they make the mistake of buying only cake—for example, stock mutual funds filled to the brim with technology stocks in the 1990s, or bond mutual funds filled to the brim with mortgages as the housing crash turned ugly in 2008. But loading up on cake, or a mutual fund that is intended to be the dessert after the main meal, is a disaster for investors.
Want to know whether you have inadvertently been loading up on cake? If you were happy at the end of the 1990s with your 401(k) mutual funds and then hated them between 2000 and 2002, you probably were guilty. You probably were unintentionally eating too much cake at the end of the 1990s, and that made your money sick in 2000. And if you had a bond mutual fund that didn’t protect you from the stock market crash in 2008–2009, you made the same mistake of overdosing on sugar.
But it doesn’t have to be this way. The strange words you see on your mutual funds are intended to help you understand whether they should be a staple, like bread, or whether they are dessert, intended to be consumed in dessert-size portions.
Soon you will be able to look at a list of mutual funds and know at a glance what each fund is intended to do for you in various cycles. When you reach that point, you will never feel befuddled again as you look over names on a 401(k) list or when a financial adviser starts chattering to you in a seemingly foreign language.
All you need is a little vocabulary. The first step is to understand what your mutual fund manager does to try to make your money grow.
What Happens in a Mutual Fund?
When you select a mutual fund in a 401(k), an IRA, or any other account, you—along with hundreds of other people—are turning over your money to an expert. You know you don’t have the expertise to examine more than 8,000 different stocks that make up the stock market. You have no idea how to determine which stocks have the potential to make you money or lose money. Nor can you examine the thousands of bonds available in the market. You’d probably prefer to devote your free time to your family, friends, or fun than to analyze whether a stock or bond might be a good investment.
So you turn over your money to a professional called a fund manager. In doing so, you tell that fund manager to spend every day trying to figure out which stocks or bonds will make you as much money as possible while also ducking excessive risks. Each day, the manager watches the economy and different businesses.
If the manager works for a so-called equity mutual fund, he or she will pick many stocks for your fund, possibly 100 or more. The word equity simply means “stocks.” So every day your mutual fund manager hunts for the best stocks for you and all the other investors in your fund. Managers analyze each business they think will make you money and determine whether both business conditions and stock market conditions are in place to stimulate a stock price higher and boost the value of your mutual fund investment. When the individual stocks in your fund are going up in price, your share of that mutual fund also goes up in value, and you make money. If your fund manager is doing a good job, your tiny savings in the mutual fund should start looking like thousands—not in a month, maybe not in a year, but after a few years.
To analyze a particular stock, the fund manager tries to figure out whether the company is producing products well, whether the products are keeping up with the competition, whether new competitors are likely to take customers away, whether the employees are creative about designing new products that customers will want, whether the sales force sells well, whether managers handle money effectively, and whether the company has the money to fulfill its innovative plans and make profits grow.
The Key: Company Profits
Analyzing a company’s profit potential is the name of the game. And it’s not easy to do. Superficial guesses—the types that ordinary investors make when they try to pick individual stocks on their own—don’t work.
Typically, when a company’s profits grow—especially if profits grow more than investors thought they would—the company’s stock price goes up. So if you own the stock of a surprisingly profitable company, or if your mutual fund owns that stock for you, you make money on it.
When a fund manager spots a company with potential, he or she might buy the stock—or not. First, the manager examines the stock price and compares it to the profits he thinks the company will generate. Managers want to make sure they don’t pay too much for the stock, and the only way to know is to scrutinize the company’s profit potential.
If the manager thinks the company is going to delight investors with more profits than anyone expected, that’s a good sign that investors will make money, and the manager might buy the stock. If the manager spots a threat— perhaps a new competitor for that company—he or she might not buy the stock, even though it’s been a tremendous success in the past. If the manager thinks a company might have trouble borrowing money at a low interest rate, he or she might not buy the stock because the company could have difficulty making or selling products if it doesn’t have enough cheap cash. The analysis goes on and on.
Meanwhile, other investors are eyeing the same stock. If many of them are excited about the company’s growing business at the same time, they will snap up the stock and the stock price consequently will soar. Under those conditions, your fund manager might decide that the stock price is too high and won’t buy it.
High Stock Prices Can Be Warning Signs
This is often a shocking revelation to novice investors. Why not go for it if the stock price is soaring? However, the manager’s decision isn’t based solely on the quality of the company or the recent delicious gains people have made on the stock. The manager might think it’s a phenomenal company with great products and smart managers, but when stock prices get too high, stocks are vulnerable. High-priced stocks fall hard, hurting investors with the slightest misstep. Managers know that a sudden unexpected turn in the economy could change the outlook for a hot company, reversing the cycle that was carrying the stock higher and higher.
So instead of buying a stock at an extremely high price, cautious fund managers might determine that they want to own the promising stock for you, but at a lower price. If you make a point of shopping for clothes only when they are on sale, you understand this concept completely. Perhaps you’ve had your eye on a sweater, but it’s expensive. So you wait to buy it, knowing that the store will offer a sale in a couple weeks and mark down everything 25 or 30 percent. Then you will buy—you will get the same sweater you wanted, but at a more reasonable price.
As you walk out of the store, you will commend yourself for finding such a “good value.” In the mutual fund world, the funds that are conscientious about shopping for “good values” actually alert you to that discipline sometimes through their names. (I tell you how to spot these so-called value funds in Chapter 9, “Know Your Mutual Fund Manager’s Job.”)
Fund managers are always busy looking for deals—or stocks that appear to be marked down temporarily. Shopping for them is slightly different from shopping in a store. That’s because the fund manager doesn’t know when the stock will go on sale. It might take months or years.
For an extreme example, consider the terrorist attacks of 2001. After the terrorists crashed airplanes into the World Trade Center and the Pentagon, investors were fleeing stocks—especially hotel stocks—as Americans stopped traveling. The stock prices plunged below bargain-basement levels. That’s when Oakmark mutual fund manager Bill Nygren loaded up on stock in Starwood Hotel (Sheraton and Westin). At the time, it seemed like Americans would never fly again, but Nygren told me that he couldn’t imagine Americans giving up on vacations or one-on-one business meetings with clients forever. As fears eased and people traveled again, the stock became a winner; it climbed about 55 percent in 2003 and 65 percent in 2004.
In the financial crisis of 2009, American Express stock plunged from more than $60 a share to less than $10 as investors worried that virtually every bank and financial company would collapse. Then as investors overcame their fear, studied American Express, and decided that it would not implode, the price soared 126 percent that year—a phenomenal gain as other financial companies remained suspect.
Even when the price of a stock comes down and fund managers consider buying it, they don’t leap immediately. They reexamine the company to make sure that, while they were waiting for a good price, the company didn’t slip in some way that might stifle profits in the future. Stock prices can fall for many reasons, sometimes because a company is making mistakes, but other times because of something less troublesome, such as a temporary downturn in the economy. For example, stores might see their sales slow during recessions, but powerful companies such as Wal-Mart and Home Depot usually come back to life when the short-term economic pressures subside.
No assurances exist, however. To make sure the company has no hidden problem when an attractive stock dips in price, the fund manager goes back to his or her original analysis and reexamines how the company produces and sells its products. Managers want to know what profits to expect so that they can determine whether the current stock price is a good deal. It doesn’t matter what stock price existed in the past or what the profits were like in the past. It doesn’t matter that people got rich on the stock last year or during the last ten years. Only one thing matters for the stock’s future: what profits the company will generate in the future.
Novice investors who buy stocks themselves often make a major mistake with this: They look at a stock price of $20 and say to themselves, “It’s a great deal because people used to buy that stock at $50.” But that’s flawed thinking. Stocks have no memory. Yesterday’s price will never be repeated again unless the company becomes more profitable than investors are anticipating.
Want an example? In the preceding chapter, I mentioned Polaroid, a high-flying stock in the 1970s. Investors loved it with the same intensity some had for Amazon in the 1990s or Apple and Google recently. Analysts told investors to pay higher prices for Polaroid because it would never go down and disappoint them. But you know now that camera products have changed dramatically since the 1970s. Polaroid’s stock hit a high in the early 1970s, crashed, and never got back to the price that gullible investors paid for it.
Repeatedly, the glorious stocks of certain periods fade when competition changes. And individuals who aren’t watching closely and who fall in love with a tremendous winner get brutalized. For example, investors adored the company that made BlackBerry smartphones when the phones were first introduced to the market and every American with money wanted one. The stock price of BlackBerry-maker Research in Motion (RIM) shot up to $140 in 2008. But then came the flashier iPhone. Suddenly, the BlackBerry became passé, and investors who missed the change lost almost all their money on the stock as it fell to $7. It didn’t matter that the stock price had once been at $140. What mattered was that people weren’t buying BlackBerry phones, and the profits were going to Apple—not Research in Motion.
When your fund manager looks at a stock, he or she focuses on the outlook for profits at that company for the next quarter, the next year, and so on.
Fund Managers Baby-Sit Stocks
If everything checks out and the manager thinks the company is on the road to being more profitable, he or she buys the stock. Then the manager watches that stock every day, looking for warning signs that the business might be losing its footing. If any concerns arise, the manager tries to sell the stock before it plummets. If the manager fails to pick up on problems early, the stock could fall hard—and you could lose some money.
Besides watching for problems, managers are equally vigilant about the winners in the fund, knowing that stocks will climb only so far. When managers think that point is nearing, they often sell the stock and, with that money, try to buy another stock that is cheaper and, consequently, more promising for the future.
Before fund managers buy a new stock, they look at a list of stocks they’ve been keeping and try to identify a favorite company that temporarily has a cheap stock price compared to the profits the manager expects the company to generate in the future.
In other words, the manager tries to “buy low and sell high,” a comment you might have heard about buying stocks. It’s the key precept of good stock investing—and the most often abused because people are emotional. Instead of buying a cheap stock that will soar over time, people get sucked into the excitement and hype over the hot stocks of the moment. They buy expensive stocks, like BlackBerry’s Research in Motion, just as the cycle for that stock is about to peak and smart fund managers are getting ready to dump them.
What’s in Your Fund?
Many mutual funds contain 100 to 500 different stocks. So when you buy a share in your mutual fund with your 401(k) or IRA money, you end up owning a tiny, tiny piece of many companies. For example, if your mutual fund invests in Apple, you own a teeny piece of all the Apple stores. If your fund invests in General Electric, you own a miniscule piece of the company that makes everything from stoves to jet engines. If your fund owns McDonald’s stock, you own a smidgen of the restaurants, and you hope that people continue to want to eat hamburgers or that McDonald’s will figure out how to attract customers with other foods.
If, on any particular day, investors think consumers are squeamish about hamburgers or that McDonald’s has lost the knack for making as much money as it has in the past, the stock price will fall, and your mutual fund will lose money on that stock that day. But you might not lose money overall in your mutual fund, because you will have dozens of other stocks to cushion the McDonald’s blow. For example, General Electric and Apple might look like they’ve got their act down, and their stock prices might be rising nicely on the same day McDonald’s is losing ground.
When you have a mutual fund, each individual stock is not as important as the mixture of stocks. So your fund manager intentionally tries to blend stocks that act differently from each other during cycles. If your fund manager buys more stocks that climb rather than fall, you will make money. But you will always have some losers. Some companies will make mistakes in their businesses, so the stocks will turn into rotten investments—maybe temporarily, maybe for as long as the company survives. Your fund manager will try to spot the problems early and sell the stock before you lose a lot of money on it. But that’s often not possible.
Unforeseen shocks always arise. For example, although investors did well with hotel stocks after the terrorist attacks in 2001, the shock pulled the rug out from under airlines. Many ended up in bankruptcy.
Then there’s Merck, which makes prescription drugs. It was a glamorous stock at the end of the 1990s. But in 2004 the stock plunged from about $45 a share to $33 in just one day after Merck pulled its blockbuster product, Vioxx, off the market because of evidence that the painkiller was dangerous. In other words, in a single day, an investor—whether a person or a mutual fund—lost about 27 percent of the money invested in the stock. Amid hundreds of suits over patient deaths and illnesses, the stock continued to drop. Investors lost about half of their money within months. By 2006, Merck stock was climbing again, but many investors bailed out long before that happened.
Here’s the important point I want you to keep in mind about mutual funds: Your opportunity to survive a stock blow-up is tremendously enhanced if you own mutual funds than if you try to select a handful of individual stocks. If you had a mutual fund that invested in Merck, you would have lost a little money because of the Vioxx mess. If, however, you had simply purchased the individual stock and decided to flee, you would have lost about half the money you had invested in it. In your mutual fund, you had protection. You had many other stocks that were great investments at the time of the Merck fiasco, and the strong stocks buffered your loss. You probably didn’t feel it a bit.
Cycles Take Stocks for a Ride
Aside from corporate disasters such as Vioxx, cycles work on the different stocks in your mutual fund in different ways. For a while, investors will be enamored with retail stocks like Wal-Mart, and that company, like other retailers, will be on a roll in the stock market, riding the cycle for retail stocks higher and higher. Meanwhile, investors might not be particularly excited about some other type of stock.
For example, investors didn’t want anything to do with gold mining stocks for roughly two decades before the 2000s. Yet in 2005, those stocks shot up almost 33 percent as investors worldwide started stockpiling gold as they feared inflation and geopolitical unrest. Also, throughout the technology craze, investors snubbed energy stocks. Yet for 12 years after that, from the beginning of 2000 to March 2012, investors made more money in energy stocks than any other industry. Energy stocks gained 156 percent, while technology stocks lost 52 percent of investors’ money, and banks and other financial stocks lost 41 percent. Investors didn’t want to touch bank stocks as losses mounted on mortgages and mortgage-related investments.
Eventually, every cycle—no matter what is hot at the time—will turn. Mutual fund managers who seek bargains will say to themselves at some point, “Bank stocks aren’t popular now, but I can find good deals on those stocks. I’ll buy them and hold on to them until they turn popular again, making the investors in my fund a lot of money.” Or at some point they will say, “People are going to cut back on gasoline if they lose jobs in a recession, so I’m going to sell Exxon and other energy stocks now, while I can still make a good gain.”
The mixture of stocks you get in mutual funds insulates you from different cycles and also from a particular company’s stumbling. At any time, some stocks in your fund will be falling, but the rising stocks will cushion the fall so that your money keeps growing or shrinks merely a little, recovering a short time later.
When your mutual fund owns a lot of stocks that are going up, you will be making money. If the fund manager makes a lot of mistakes and buys more losing stocks than winners, you will lose money—at least temporarily.
Good Funds Can Be Losers
Picking stocks is difficult, even for the most brilliant fund managers. Some of the nation’s top managers have told me they regret about 40 percent of the stocks they pick. They inevitably make mistakes on forecasts for the economy and companies. Because the stock market runs in cycles, your mutual fund will sometimes lose money even though the fund manager has selected excellent stocks.
Cycles hit certain types of investments, or groups of stocks, without warning. Entire industries, or what are called “sectors,” get hurt as a group. By groups, or sectors, I’m referring, for example, to all energy company stocks, or all manufacturing company stocks, or all retail company stocks, and so on. When people worry that consumers won’t be shopping much, for example, everything from Costco to Home Depot and Gap might go down together. This is important to know because if, for example, you owned Costco stock and were watching only it, you might see the stock price fall and think something was wrong with your stock alone. In fact, Costco might be suffering temporarily in a cycle that will turn.
Cycles also hit various parts of the world at different times. In the late 1990s, investors ran away from Latin American stocks in terror, as companies suffered from economic and political turmoil. Investors swore they’d never put a penny into Latin America or other emerging or developing nations again because they’d been burned so badly. Yet if they were still snubbing Latin American companies in 2005, they missed out on an astronomical 76 percent return as China and the rest of Asia hungered for Latin American oil and natural resources.
As an investor, you won’t get hurt by any of these cycles if you don’t overdose on anything that looks overly enticing—like energy companies amid a boom or Latin American stocks riding the wave. Your future depends on recognizing what’s making each mutual fund do what it’s doing and knowing that cycles will affect various mutual funds differently. You need to know this whether your funds are bestowing riches at the moment or sucking wealth away from investors.
This might sound like a mammoth task. But I’ll teach you an easy shortcut. It simply involves recognizing some befuddling names that currently make mutual funds appear confusing. You are about to learn how to eye mutual funds quickly and choose them with confidence.
I’ll start walking you through the process.