I have often been approached by, and read reviews by, individuals who claim that most people should just “buy an index fund” when they are trying to decide how to invest for their future.
I’ve hinted at that idea too a few times. Not everyone mind you. If you’re the type that wants a little action, but you aren’t really that good at analyzing stocks go for it…well not right now. But it might have worked out for you alright in the past. In truth, it’s not a great strategy, but heck, it’s a better approach than what most mutual fund managers have in store for you.
Here’s the real danger of investing in index funds: Look at the S&P500, today. Look at the DOW, today. Look at the NASDAQ, today. If you’re an index fund investor, you had a bad year this week. If you’re that “buy and hold” type, you just gave up all of the gains you made post 2000 after recovering from the tech bubble crash!
A while back, I wrote an article titled “The Trouble With Mutual Funds”. In that article, I explained a major problem with mutual funds. The liquidity issue:
There is a special type of liquidity issue with mutual funds. Typically, a certain amount of investors’ dollars are not invested in the underlying investments of the fund but are instead set aside for investors who want to pull out of the fund. By its very design, a mutual fund must do this so that it can maintain liquidity when investors want to sell. After all, what good is it to own an investment if you can’t sell it when its performance has “topped out”? To cloud the issue, sometimes it’s not exactly clear how much of your money is actually being put to work in the market and how much is held back for redemption requests (redemption is just a fancy word for selling your fund shares).
Even if a significant amount of money is held in cash for redemption requests, there must be enough money invested in stocks, bonds, and other financial instruments to keep investors interested in investing in the mutual fund. This leads to a situation where when it is time to sell off your investment, there may not be enough cash reserves to meet redemption requests. When those cash on hand reserves are not enough to meet redemption requests the fund managers are forced to liquidate stock from the portfolio. This, in turn, can have a negative impact on the entire fund and hurt your returns if the fund manager has to sell those shares at low prices to create liquidity.
This is where today’s investors are hitting a brick wall. You see the part I put in bold?
When those cash on hand reserves are not enough to meet redemption requests the fund managers are forced to liquidate stock from the portfolio. This, in turn, can have a negative impact on the entire fund and hurt your returns if the fund manager has to sell those shares at low prices to create liquidity.
That’s causing a major problem right now. A lot of folks, active and index fund investors, are trying to get away with their own bailout plan…
…they’re bailing out of the stock market and mutual fund managers are having to come up with money that they normally don’t have available. When you pull over $52 billion from (U.S. based) mutual funds in a week, you have to believe something like that might have the potential to cause a few problems if mutual fund managers don’t have at least that much in cash just sitting around somewhere…but then, if they were that liquid…how exactly would they be investing your money to give you those 15% annualized returns that your neighbor Joe was always telling you about?
Indeed there was much selling going on last week…and there’s probably going to be a bit more in the near future. And, all of this selling is going to continue to cause fund managers to sell stock positions at lower and lower prices (hurting those who have adopted that good old “buy and hold” strategy sold to them by their friendly home-town broker) just so they can come up with the cash needed to pay off investors who want out.
If you needed another reason to avoid mutual funds like the plague, here it is: Panic will destroy your investments. After all, we can’t all be the first ones out of the market. Someone has to lose when there is a run on the markets like this.
I guess the SEC could just put a selling freeze on all mutual funds similar to their nonsensical short-selling freeze…of course, I’m wondering how that would help American investors. I’m still trying to figure out how the short-selling freeze and the $700+ billion bailout has helped “main street”. Maybe one day, a long time from now…when we’ve all but forgotten this calamity, someone who is much “smarter” than we are, will write about it in a history book…telling us that the Government came to our rescue and although it didn’t seem like a good idea at the time…it really did help us (somehow).
Where is everyone putting that money?
People are rushing to the perceived safety of Federally insured bank accounts. Meanwhile, banks put a healthy portion of their money with life insurance companies (why people insist on going through the middle man is anyone’s guess).
We are told that no one has ever lost a dime in an FDIC insured account. That may be true, but I think the losses that people have incurred from the stock market so far have more than made up for that “safety net”.
People always ask me when I tell them that mutual funds are bunk: “So, where do I put my money?”
I always smile a little bit, because I know the answer and I know the reaction that it usually elicits. Sometimes I ask these people if they want the answer that I give to paying clients or the answer I give to people who aren’t paying me…
…and as I think to myself “why am I telling them this”, I usually blurt out something to the effect of “strong cash value life insurance, gold and silver, and oh yeah, don’t forget about real estate…and in that order.”
Does anyone listen? Probably not. That’s why people are selling over $50 billion worth of mutual funds now…because they didn’t listen when other smart financial advisors (not necessarily me) told them not to invest in mutual funds in the first place.
Kudos to those who do listen. The intelligent shall inherit the Earth!