Mutual Funds Interactive -- Mutual Fund News and Features

Ready, Set, Invest!

by Bill Jones

Bill Jones Someone who is just beginning to accumulate assets for investing should begin with mutual funds that invest in stocks; individual stocks come only after you have developed substantial experience and knowledge about investing. Your initial goal is to accumulate a good "core" holding by putting $3,000 to $5,000 in each of three different kinds of stock mutual funds: one investing in large U.S. companies, one in small U.S. companies, and one in foreign stocks.

Once you have enough in your emergency cash reserves, you should put as much as you can in a tax-sheltered savings account for retirement, such as a 401 (k), 403 (b), 457, Keogh, SIMPLE IRA, and Roth IRA. The only exception might be when your tax-sheltering plan assesses fees of at least 1% above what you would pay in a non-sheltered environment and has no employer matching for contributions (many 403b and 457 plans have this drawback). In that case, a regular taxable account may be as profitable, after you maximize your IRAs. Your tax advisor can help you with those calculations to figure out what’s best for you.

Of course, your emergency reserves generally cannot be in a tax-sheltered retirement account-- except in a Roth IRA, as discussed previously--because they have to be available. Most tax-sheltered plans have substantial penalties and fees for early withdrawal. And, you cannot add more than $2,000 to an IRA each year.

Keep in mind that some mutual fund families have around a $10 annual surcharge on IRA fund balances under $5,000. For instance, Vanguard has annual expense charges that are typically 0.3% or more below those of other fund families. But part of the reason they can afford this is their extra $10 charge for very small accounts. This charge encourages people to build up their accounts quickly, and it discourages those who only want to keep a balance of $2,000 or so. Still, that $10 only adds 0.5% for a fund with a balance of $2,000, so it is still fairly reasonable. And this policy reduces your costs in future years when you have larger amounts invested, so it actually helps you in the long run.

Get the ball rolling: picking your first fund

Look for these characteristics in your first stock fund:

No sales charge, or load (front, back, or level).
Broad diversification through a fund that invests in over 100 different companies with no great concentration in any one sector or in any one company.
An annual expense ratio below 1% including 12b-1 fees; the lower the better.
For taxable accounts, an annual turnover of under 100%; the lower the better.
A good record for the past five years, if the fund is not an index fund. This means a total return that exceeds the average stock fund in its class in at least three of the past five years, and falling no more than 2% below the average in the other two years.
The same manager for the past five years, if the fund is not tied to an index.

Even with these five restrictions, there are many choices. An index fund is a safe if boring choice; you do not have to worry about the last two restrictions, and they are almost always well-diversified, have low expenses, and low portfolio turnover. Index funds usually outperform more than half of their actively-managed competitors in the long run, generally have fairly low taxable distributions (dividends and realized capital gains; this is an important consideration outside of a tax-sheltered account). Of course, "safe" just means you don't have to worry about the fund manager making bad choices. An index fund can fluctuate broadly, just like any other stock investment.

Devising a game plan

Your first purchase should be a mutual fund that concentrates in American large-capitalization companies (basically, those in the S&P 500 companies). When you accumulate enough for two mutual funds, your second purchase can be American small-capitalization companies. The third purchase can be an international stock fund. Thereafter, you distribute additional savings among the three stock funds to make them reasonably balanced, until you have a total of $10,000 to $15,000 invested in them. You might even have to make up a loss in one of the stock funds, if it drops over the several months in which you are developing this position.

How you complete this Stage One (up to $5,000 in each of three mutual funds) depends on your particular pattern of savings. In retirement accounts, the minimum balance required is usually only $1,000. So if you are saving in a 401 (k), you could put the first $1,000 you save in large-caps, the second $1,000 in small-caps, the third $1,000 in internationals, and thereafter add maybe $300 at a time to the three stock funds in rotation.

Example: say you can save $300 a month and you use only a Roth IRA (limited to $2,000 in contributions each year) and taxable accounts. A reasonable way to proceed might be to:

Start an IRA with a large-cap stock fund when you have $1,000, then add to it from time to time until you have put in $2,000. Put the rest of your savings for the first year in your money market account.

Begin investing in a small cap fund through your IRA at the start of the second year. Add to it until you have put in $2,000. Put the rest of your savings in your money market account.

Open a taxable fund outside the retirement account when you have saved $2,500 to $3,000 in the IRA. Invest this in a "tax-managed" domestic large-cap fund to minimize taxes. ( I’ll explain how these funds work late.). Switch the IRA money that is currently in a large-cap fund to an international fund.

If you are married, both you and your spouse can add $2,000 to a Roth IRA each year, so all of your savings can be tax-sheltered. It is not important which of you owns which stock fund. The main objective is to fully fund the Roth IRAs as early in the year as you can.

In the early part of this Stage One, you may have much more in one stock fund than the other; but this imbalance is only temporary. Some people may object that retirement assets should keep a balance among the three kinds of stocks, and they should include some bonds. Generally, this is true. But this first $10,000 to $15,000 is only the initial step on the road to assets that will hopefully total several hundred thousand dollars by the time you retire. And it is the money that will be in the retirement plan the longest. So a little more volatility than normal is okay at this point, particularly is retirement is still a ways off.

Now, the ride begins. Have the thrill of watching your money in stocks occasionally gain and lose 4% or more in a single month, which will probably happen twice a year, on the average. Be prepared to experience a loss of 20% or more at some point in the next five years, maybe next month. Through it all, always remember that the chances of greater returns with stock investments are accompanied by the chances of greater losses.

What About Taxes?

You will probably save the most in taxes outside a retirement plan with a "tax-managed," semi-indexed large-cap mutual fund. "Tax-managed" means that the fund tries to minimize distributions of dividends and capital gains. A "semi-indexed" fund is one that has over 200 different companies, in almost all market sectors, with the top 10 companies making up less than 30% of the total overall asset base, and an annual turnover well below 50%. Tax-managed funds are more often American stocks than international, and more often large-caps than small-caps.

Investigate Automatic Investing Plans (AIPs) with your fund family. With these plans, you can have $100 or more deducted from your checking account each month for investing in your mutual funds, and you may not need a minimum to start.

Tip: For a regular taxable account, it is a good idea not to ask for automatic reinvestment of dividends and other distributions, because these small amounts are easy to lose track of. When you eventually sell your holdings, you have to have a list of each such amount and the date it occurred, so you can minimize your taxes on the profits. If you have these taxable distributions put into your money market account as they occur, that will simplify your taxes.

From time to time, you can purchase more shares in whichever stock fund you think best; these purchases can be used to keep the funds close to equal in value. Since these purchases will be round numbers and come less frequently, they will be easier to keep track of for tax reporting. Also, be warned that, if you have the check-writing option on any fund except on the money market account, it greatly complicates your tax reporting.

If you have a large amount to invest…

Maybe you’re in one of these situations:

Special Situation #1: You are starting out with a large amount to invest, almost none of it in stocks. This might be because you inherited a large amount, or because you previously accumulated a lot in bank CDs and have now decided that is not smart. In this case, you should normally start with at most $5,000 in each of the three kinds of stock funds. Even if you have more money; be cautious until you have experience. But if you are fortunate enough to have over $100,000, you could put perhaps 5% of your total assets in each of the three stock funds. The rest should be put in shorter-term bonds or bank CDs, except for some emergency cash reserves in a money market.

Special Situation #2: You have inherited a large holding that already includes a substantial amount of stocks. It is generally best not to make any substantial changes right away, except to (1) pay off your high-interest debts, and (2) make a moderate reduction in the percentage that is allocated to stocks if you are uncomfortable with what you have. These reductions should tend to prune and simplify your stock holdings to take you roughly in the direction of one-third in each of the three categories of stock funds specified -- American large-cap, American small-cap, and international. Then spend the next year or so getting used to your new-found fortune and responsibilities, making only minor changes, while you study up on the art of investing.

In both these situations, you can gradually increase the percentage of total assets in each stock fund once every three months. Say you started with an initial 5% of total assets in each of the three mutual funds. At the end of 3 months, add enough to have around 7.5% in each stock fund. At the end of 6 months, add enough to have around 10% in each stock fund. Continue until, one year after you start, you have around 15% of your assets in each of the three stock funds. This is a form of "dollar-cost averaging "(except for the initial minimum investments). I don't think people should go any further than half of total assets in stocks until they learn enough about investing to make a sound investment plan.

In both of these special situations, consider getting some help and advice from a trusted friend or paid financial advisor, especially on the tax consequences of any changes. But be sure that any advice outside the parameters discussed above is very well justified. In particular, kindly refuse their suggestion to shift to a different kind of stock investment "because it will perform better." They may be right, but it is your money and you will have to suffer the consequences of an error, so wait until you can independently decide for yourself whether that particular shift is a good idea. You can lose a friendship if the other person's suggestion turns out wrong, and any such suggestion has at least a small possibility of losing a lot of money.

William C. Jones, Jr. was born in Chicago in 1944. He obtained the Ph. D. in Mathematics from Purdue University in 1969. He has taught full-time in the Departments of Mathematics and Computer Science at Central Connecticut State University since then, except for a year teaching at the Bundeswehr University in Hamburg, Germany in 1981-82. He earned a Master's degree in Computer Science in 1989 and has had three textbooks in Computer Science published, by Harper & Row and by John Wiley.

Dr. Jones has been investing all of his retirement assets in equity and bond mutual funds since 1974. He is married to Virginia, who also teaches Mathematics and Computer Science at CCSU, and they have a daughter working on her Ph. D. in Mathematics. Dr. Jones is also a frequent contributor to the MFI newsgroups.

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