Questions and Responses
Are mutual funds a good investment for a
college student?
from Holly
Q: I am a college student looking for a safe
investment that will earn substantial interest. I plan on investing about $1,000 and
leaving it there for a good while (about 20 years) and at the same time adding a little
every month. Are mutual funds the best way to accrue interest, how safe are they, and how
do I go about choosing which funds are the best for me?
A (Greg): I hope you
realize that 1) by starting young 2) by investing regularly and 3) by letting it grow you
are destined to get rich - slowly!
First of all, there is a lot to know about a person before I can
feel comfortable giving specific investment recommendations but I can safely say that
based upon your time horizon (20 years) you should forget about the notion of
"interest" and think about "capital appreciation" (a.k.a. growth).
Secondly, you also need to diversify (place your eggs in several baskets) and the best way
to do this is through mutual funds. A fund manager will take your money and mix it with a
lot of other investors in order for him to apply his professional investment knowledge.
Thirdly, which mutual fund you invest in will depend on a lot of factors such as your risk
tolerance. Even though you aren't giving me a lot to work with I can still safely
recommend to you something called an index fund. An index fund simply buys stocks that
make up a particular market index (like the S&P 500) so, come what may, that fund will
follow that index. This is called passive management and surprisingly will out perform a
vast majority of the professional money managers. Additional benefits include low
management costs, low transaction costs, and few capital gains to pay tax on.
Finally, when you go to open up your brokerage account (preferably
at a discount broker) I would like you to inquire about an IRA. Since you are investing
long-term you might as well do it on a tax deferred basis. You will also find that IRAs
have smaller minimum initial deposits and automatic investments. The only thing you will
need is some earned income from working.
Good luck and drop me a line if you get stuck.
Where can I find standard deviation
figures?
from Bill
Q: I have set about serious evaluation of my
portfolio and have had a problem finding info such as standard deviation and correlation
figures that I can trust (numbers vary- some times greatly- between sites). If you have
any research sites to share I would appreciate it.
A (Frank): The folks that
compile and publish this data generally hate to give it away for free. I spend a good
portion of my allowance each year to purchase data and software to build asset allocation
strategies.
You might try Morningstar's Principia for Mutual Funds on CD. It
includes data on what seems like hundreds of indexes. With a little manipulation you can
extract monthly data for over ten years. Or you can just use their summary data as if the
index were any other mutual fund. See: www.morningstar.com.
[Ed. note: Caution - This site is a pay-per-view site, though it also provides
some free information.]
Another choice for data and spreadsheets is William F. Sharpe's home
page. He also maintains links to a number of other sources that have limited sets of data.
You may be able to cobble enough together to meet your needs. See: http://www-sharpe.stanford.edu/returns.htm
If you are really serious and willing to shell out Ibbotson
Associates has several databases and software combinations that will do just about
anything in the way of analysis for portfolio construction or analysis of an individual
index return. See www.ibbotson.com
Data often seems contradictory when time frames are not exactly the
same. Another potential problem is that reports show data as "average" returns
while others report as "compound" returns. Compound numbers will often appear
1.5% or so lower than average returns.
All this data and software must be used with a great deal of
discretion and skepticism. Tiny changes in assumptions can drive any optimizer from one
extreme to another. Few investment advisors allow an optimizer to build an asset
allocation plan. But, it's great for checking to see if your plan makes sense, or to help
you to understand concepts of portfolio construction.
How can I differentiate "value"
from "growth" funds?
from Daniel
Q: I am looking for a value small cap fund and a growth small cap fund. I have a
difficult time differentiating between growth, aggressive growth and value funds. Many
funds have value in their name but when you read their investment approach they claim they
look for stocks with growth potential.
Other funds state they look for undervalued stocks but on closer
inspection have many growth stocks. Magazines, newspapers, online services, Morningstar,
etc all have their own classification schemes and can categorize the same fund
differently.
Do you feel the managers investment statement, the price book ratio
or the price earning ratio is the best indicator of a value vs. growth approach? What
arbitrary values of PB and PE ratio do you use? Have these values changed over the last
couple of years as the overall market valuation has risen? What is your definition of
aggressive growth.
A (Greg): I believe that
the fund classifications you inquire about are colloquial terms. By that I mean they are
popular, common, idiomatic terms and are thus not subject to precise definition that would
prevent two people from disagreeing as to the classification of a specific fund. Let's
review the main categories:
Growth funds invest in mid to big size companies whose earnings are
on the increase.
Aggressive Growth funds buy hot new issues and small companies whose
earnings are rising fast.
Value funds invest in good solid companies that are considered
undervalued.
Small Company funds are susceptible to a quantitative meaning.
Generally a stock is small-cap if its total market capitalization (market price times
shares outstanding) is less than $500 million (although I've seen some managers set this
at $1 billion).
Growth and Income funds buy solid companies with steady growth and
which pay dividends.
Income and Equity-Income funds look for high dividends without
consideration for growth.
Balanced funds buy both stocks and bonds in whatever allocation the
manager wants.
The Investment Company Institute has added to the above list and
grouped funds into 21 different categories by investment objective, which can be found in
every fund's prospectus. The problem is that the fund's manager might change his style as
the markets change and all of a sudden your fund does not resemble the original fund that
you purchased - this is called style drift and needs to be monitored during your regular
portfolio reviews.
Can I retire as a millionaire by
investing $5 a day in mutual funds now?
Q: I am 40 years old and I want to start in a
retirement plan. I heard on TV that if I were to put $5 every day in mutual fund
investment for 20 years I can accumulate close to a million dollars. Is that true?
A (Frank): Five dollars a
day is $1825 a year. At that rate, to accumulate $1,000,000 in just 20 years an investor
would have to realize a net compound return of 26.89% per year. That's more than twice as
much as I would ever dare to project.
At a more realistic 11% per year, $1825 per year grows to
$130,058.89. So, you can see that assumed differences in return can add up to substantial
differences in projected accumulation.
However, the idea of disciplined periodic investing over long
periods of time is a sound one. More investors should act on it.
Comments? Criticism?
Suggestions?