Mutual Funds

To those in my audiences who hold investments in Mutual funds, here is a PSA from your friendly neighborhood Mathematical Economist. I plan to do some more general investment advice in the following weeks. I would like to start with Mutual Funds, because they represent arguably the largest holdings of Canadian public retirement savings. A mutual fund allows you to buy a share of an already diversified portfolio, and for the benefit of this diversified risk you pay fees that skim your annual profits. Different funds charge different fees, some are better than others, and then there is Primerica. Don't get roped into Primerica. It is a legalized pyramid scheme. If you buy one of their mutual funds, you are paying out money to a whole bunch of people.

Here is the other danger about buying mutual funds. Many of the "advisors" telling you what you should own are not sitting in that chair because they are brilliant investors; they ascended to their post because they are fantastic salesmen. The "inconvenient truth" that many of these people don't you want you to know is that virtually any diversified portfolio will mimic the market once you own and 12-14 different stocks. You can even buy "shares" in the Toronto Stock Exchange, where your holdings just go up and down at the same rate as the entire market, which will trend upwards over time (despite occasional downturns). There is an entire industry that profits billions of dollars off of your money annually doing something that you yourself could easily do at home!

Diversifying a portfolio is quite easy. Own shares in one bank, one automotive company, one food company, one mining company, one energy company, one major computer company (like Apple, Intel, Microsoft, or RIM), etc, etc. Infact, if you lease a Toyota and have $1000, go buy shares in Toyota. That way each time you pay your bill at the end of the month, your money is making a positive contribution to a company that you own equity in. If you buy gas at Schell, buy shares of Schell. If you own an Apple Computer, buy shares of Apple. Do you see where I am going with this? Buy shares in companies from which you consume their products.

For example, I was once out enjoying some alcoholic beverages with a friend and his investment advisor. The whole night I was prodding the guy with investigative questions about my friend's retirement savings. Eventually I wore him down and dared him: "I bet you $100 of real money that I can select a group of 15 stocks completely at random with $30,000 of imaginary money and put them up against an imaginary $30,000 basket of your mutual funds and win." He quickly jumped in and agreed to the bet. He regretted his decision almost immediately, and tried to weasel out of the bet. The next morning he invoked the "I was too drunk" card, and then threatened me with a lawsuit when I sent an e-mail to a group of friends describing how this man had chickened out of a real bet that he had made.

The reason he made a mistake, is because I had a disproportionate probability of winning. If I could defeat his investments by dropping a bunch of pins on a newspaper listing, that not only would be embarrassing, but would belittle his entire profession. Most funds hit you with a fee to join, you pay a management fee while you own them, then you pay an exit fee when you leave. You could do far better running your own diversified portfolio.

So here's a challenge to those of my readers who own a significant portion of their retirement savings in mutual funds. Take that dollar amount you have invested, then randomly select 15 stocks from the stock exchange and buy as many shares of each as you can with 6.7% of your total holdings. Chart your imaginary portfolio against your real holdings. See how you do.