Darcie Guerin, CFP®
“Muddy waters make for good fishing.”
Daniel Drew, American financier, 1797-1879.
Answer: First, I’ll give you the same advice I give our grandkids and that is to take the word “should” right out of your vocabulary! Until a concept is explained to you in the way you can grasp it, there’s no reason you’d master terminology not used in your day-to-day life. As my husband often reminds me, financial professionals are guilty of using jargon and vocabulary unique to our industry. This is the place to ask your questions.
“Splain it to me Lucy…”
To explain the mutual fund concept I use two illustrations. The first begins with a virtual trip to the grocery store. You are the fund manager and the cart is the fund. The aisles represent investment objectives and individual sectors while the items in your cart are the specific holdings in your fund. If the goal is to make oatmeal cookies, you’ll need things like eggs, sugar, flour, and oatmeal. On the other hand, a pot roast dinner would require visiting the meat department and vegetable aisle. The objectives and ingredients are different yet the concept is the same. A balanced mutual fund would equate to the pot roast while the oatmeal cookies compare to a more specialized fund. Both provide nutritional value yet have different roles in meeting your overall needs.
The second depiction of a mutual fund involves visualization. Envision a large bay window and compare this to a multi-paned window in your mind’s eye. If the windowpanes represent individual stocks and bonds, it is logical that the likelihood that diversification may minimize risk. Rather than owning only one company in the large picture window for example, mutual funds provide exposure to numerous companies represented by the segmented pane glass windows. If someone throws a rock at your window, it is typically advantageous to replace one pane of glass rather than the entire bay window. Likewise, if one stock is out of favor, the impact may be less devastating to your portfolio.
Mutual funds are simply tools to implement your individual investment objectives. They allow you to achieve the desired mix of stocks, bonds, cash, and other asset classes to match your goals. Beyond that, funds are also a way of zeroing in on specific sectors of the market that an investor believes are promising. (Think oatmeal cookies.)
Mutual funds offer benefits including professional investment management, diversification, ease of purchase and sale, and the ability to target specific areas of the market. Professional management is a primary reason for owning mutual funds and many investors are interested in fund performance.
Look beyond the numbers to see who is running the fund, their tenure, the outlook, and type of management expertise on the bench. This information may be obtained from the funds’ website, prospectus, or your advisor and should be read carefully before investing. A fund with an impressive record under a specific manager or team may not do as well under other management. Tenure isn’t just about how many years the manager has been in charge, the real issue is what kinds of markets the team has been through and how they’ve performed during those cycles.
After reviewing performance and tenure, the next step is to analyze how performance was achieved. Managers may have similar results, but it could matter to you if they travelled a winding mountain road or journeyed along a smoothly paved highway. Investors typically choose managers whose overall approach to investing and attitude toward critical issues such as risk tolerance and volatility are close to their own sentiments.
There are additional complexities and quantitative measures such as Beta, Alpha, R-squared, Sharpe Ratios, etc. that analyze performance and volatility. Beta compares volatility of a security with an index, such as the S&P 500. A beta of one means the security has volatility equal to that of an index. Alpha compares a fund’s actual returns with those that would be expected by its beta. A positive alpha means that for the given amount of volatility, the fund returned more than expected when compared to the4 benchmark index. Alpha and beta measures are historical. R-squared is a statistical measure that represents the percentage of a security’s movements that can b explained by movements in a benchmark index, such as the S&P 500. R-squared value range from 0 to 100. An R-squared of 100 means that all movements of a security are completely explained by movements in the index. A higher R-squared value will indicate a more useful beta figure. The Sharpe ratio attempts to measure risk adjusted performance.
It is best to discuss the more complex concepts with your financial advisor who can translate the terminology. Knowledge is power. Keep asking questions, interpret the information, then implement and apply it as it pertains to your overall financial plan for well-being, and peace of mind. Stay focused and invest accordingly.
Investors should consider the investment objectives, risks, charges, and expenses of mutual funds carefully before investing. The prospectus contains this and other information about these investments. The prospectus is available from Darcie Guerin and should be read carefully before investing.
Asset allocation and diversification do not guarantee a profit nor protect against a loss. This information is general in nature, it is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or solicitation to buy or sell any particular investment. Investing involves risk and the possible loss of principal invested. There is no guarantee any particular investment strategy will be successful. Opinions expressed herein are those of the author and subject to change at any time.
“Certified Financial Planner Board of Standards Inc. owns the certification marks CFP(R), CERTIFIED FINANCIAL PLANNER(tm) and federally registered CFP (with flame design) in the U.S.”
This article provided by Darcie Guerin, CFP®, Associate Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at (239)389-1041, email firstname.lastname@example.org Website: www.raymondjames.com/Darcie.