Novak Online Tax & Acounting
Tony Novak, CPA, MBA, MT
(610) 572-1724 firstname.lastname@example.org
Ten Common Mistakes of Mutual Fund Owners
by Tony Novak, CPA, MBA, MT
published 9/7/2004 and revised 11/29/2011
Mutual funds are one of the breakthrough tools of modern investing, but many owners hurt themselves by ignoring key issues that impact the long-term net investment results. Here are ten common mistakes that lower investment returns for many mutual fund owners.
1. Owning the Wrong Class of Shares – “Class shares” is the term used to describe the method that a mutual fund allocates its marketing charges to investors. Other things being equal, lower charges are presumed to be better for investors. Actually, there is no clear evidence that one class of shares is better than another class of shares. Mistakes occur when an investor does not match the best share type for her investment situation. Choosing the wrong share class can cost an investor tens of thousands of dollars over their lifetime.
2. Chasing Past Returns – An investment that was a star performer over the last year or the last 10 years is no more or likely to be successful this year than any other mutual fund. It simply does not make sense to consider past investment performance as a factor in the selection of one mutual fund over another. Chasing last year’s return is likely to increase your transaction costs and overall portfolio risk.
3. Intimidated By Minimums – Some investors bypass the best mutual funds they really want to own because they do not yet meet the minimum investment account size. Most funds and advisers provide methods to override the minimum initial purchase amount. All you need to do is ask!
4. Ignoring Taxes – Investment returns are boosted by postponing or avoid taxes on investment earnings. Investors who ignore taxes on mutual funds can set themselves up for nasty surprises. As recently as 2000, mutual fund owners paid significant taxes on mutual funds shares even though the value of their accounts when down for the year! There are many strategies that can delay or eliminate taxes on mutual funds, but these cannot be fully discussed in this short column. Consider retirement plans, annuities, Roth IRAs, medical savings accounts or health savings accounts, trust accounts, or other tax-advantaged approaches.
5. Timing of Transactions – Mutual funds pay dividends to the owners of record on certain days, known as “ex dates”. Dividends are taxable income. If you want the dividend, buy before the ex date. If not, wait until afterward. Many investors ignore this and may wind up “buying” an unnecessary tax bill. The same concept is true in reverse with regard to tax losses, known as capital losses. You can, for example, buy a long-term capital loss to help reduce your taxes even if you did not own a mutual fund for a long time.
6. Ignoring Dollar-Cost Averaging – One of the key advantages of mutual funds is that they allow investors to accumulate shares at a lower than average cost if even dollar amounts are invested over a period of time. This is called dollar cost averaging simply a mathematical trick attributed to the fact that more shares are purchased when the price is lower than average, fewer shares are purchased when the price is above average. The beauty of this tool is that it is not even necessary that the investor knows what is the “average” price of the investment – it just happens automatically! Investors who do not take advantage of this miss out on a great wealth-building tool.
7. Ignoring Legal Risks – In this litigious society our investments are exposed to numerous legal risks. Some investments are less risky than others. It makes sense to structure the ownership of investments, including mutual funds, in the manner that minimizes legal risks. A mutual fund owned by your pension plan, for example, is protected from business creditors. A mutual fund owned in trust for your children is better protected from the liabilities of a spendthrift spouse. Consider the most significant risks, and structure mutual fund ownership accordingly.
8. Mismatching Investment Volatility or Holding Period – this is perhaps the oldest mistake in the world of investing. Some investments go up and down in value more than others. This is called volatility. In general (but not always) the greater an investment’s volatility, the greater its long-term rate of return. Consequently, earning high rates of investment returns is often accompanied by period of enduring large drops in account value. It you are a person who cannot sleep when the markets drop then you must avoid volatile investments. It makes absolutely no sense to purchase an investment with a high expected rate of return and then sell it because it dropped in value more than you felt was acceptable. The investment was performing exactly as expected, but rather it was the owner who has the problem. Most investment companies and advisers try to educate investors on this concept, yet more money is lost collectively by investors caught in this mistake than any other type of poor investment decision.
9. Over-diversification – Diversification of investments is a good thing, but over-diversification with mutual funds can be expensive. Most experienced investors know that the optimum number of securities an investor should own is mathematically determined as the specific combination that provides the highest rate of return at the lowest overall risk. But man investors do not know that the optimum number of mutual funds is significantly less than the optimum number of stocks or bonds that would be in the most efficient portfolio. Larger mutual fund accounts (or the collective total of a number of associated smaller investors) often receive discounts on mutual fund fees and administrative fees. An investor who hires two or more money managers who independently devise excellent portfolios will result in the overall effect of creating a portfolio with greater risk than if the portfolio were managed as a single pool of assets. This is because each manager does not know what the other is doing and cannot possibly place investments on the optimum risk/reward level, known as the “efficiency frontier”. For this reason, it is important for large accounts to have a single overseer or adviser to coordinate sub-accounts and managers.
10. Changing Course Too Often – Once a well-balanced investment portfolio is assembled, most investors would be best leaving alone for at least a decade. Most mutual funds are not suitable for short-term investments. If you find yourself moving from one mutual fund company or mutual fund to the next every few years, there is an indication of a significant management problem. Many mutual fund companies now offer free automated asset re-allocation services to automate long-term investment management. This is really all an investor needs to maintain a solid portfolio for the long term. Your goal should be to feel so comfortable with your investment decisions that you can literally throw away the quarterly investment performance account statements unopened.
Mutual funds are among the “most likely to succeed” investment vehicles for those who simply avoid these common ownership mistakes.
Status: available for reprint
This article is available for republication in its entirety without charge after obtaining the express written permission of the author.
Pleasee-mail a request to the author that includes the name of the requestor (individual and corporate) and the intended destination of publication.
This Web site is independently owned and operated by Tony Novak operating under the trademarks “Freedom Benefits”, “OnlineAdviser” and “OnlineNavigator”. Opinions expressed are the sole responsibility of the author and do not represent the opinion of any other person, company or entity mentioned. Tony Novak is not a representative, agent, broker, producer or navigator for any securities broker dealer firm, federal or state health insurance marketplace or qualified health plan carrier and has no financial position in any stocks mentioned. Novak may act as and be compensated as an accountant, agent, adviser, writer, consultant, marketer, reviewer, endorser, producer, lead generator or referrer to the companies listed on this site or other commercial companies and non-governmental insurance exchanges. Information is from sources believed to be reliable but cannot be guaranteed. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
141 Jones Street, Bala Cynwyd PA 19004 | P.O. Box 333, Newport NJ 08345