The Sampson's Savings: Mutual Fund Investment Strategy

The Sampsons should consider investing their savings in mutual funds if they want to diversify their portfolio and benefit from the stock market's high average annual returns without having to pick and choose individual investments. Mutual funds are a good option for investors who want a relatively hands-off approach to investing in a variety of assets at once. They are also a good option for those who want to take advantage of dollar-cost averaging, which cushions a portfolio from the impact of price volatility.

The advantages of mutual funds

Mutual funds are a popular investment choice, especially for those who don't want to pick and choose individual investments themselves. They are a relatively hands-off way to invest in many different assets at once. Here are some advantages of mutual funds:

Diversification

Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy. By putting money into a mutual fund, you invest in a collection of companies, which reduces the risk to your overall portfolio.

Professional Management

Mutual funds are managed by professional portfolio managers who buy and sell stocks, bonds, etc. This is a relatively small price to pay for getting professional help in the management of an investment portfolio. Fund managers do the research for you, selecting securities and monitoring the fund's performance.

Dividend Reinvestment

Mutual funds allow for the reinvestment of dividends and other interest income sources. As dividends are declared for the fund, they can be used to purchase additional shares in the mutual fund, helping your investment grow.

Risk Reduction

Most mutual funds will invest in anywhere from 50 to 200 different securities, achieving reduced portfolio risk through diversification. Numerous stock index mutual funds own 1,000 or more individual stock positions.

Convenience and Fair Pricing

Mutual funds are easy to buy and easy to understand. They typically have low minimum investments and are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation throughout the day and various arbitrage opportunities that day traders practice.

The risks of mutual funds

Investing in mutual funds comes with a certain level of risk, just like any other investment. Here are some of the risks associated with mutual funds:

Market Risk

The value of the fund's investments may decline due to unavoidable economic developments or events that affect the entire market. This can lead to a potential loss of some or all of the principal amount invested.

Liquidity Risk

Liquidity risk refers to the ease of selling a security at or near its fair value. In the case of mutual funds, there is a chance that the fund won't be able to sell an investment that is declining in value due to a lack of buyers.

Credit Risk

Credit risk is associated with fixed-income securities. There is a possibility that the issuer of a bond or other security may default on their interest payments or be unable to redeem the bonds for their face value when they mature.

Interest Rate Risk

When interest rates rise, the value of fixed-income securities, such as bond prices, tends to fall. This, in turn, can lead to a decline in the value of bond mutual funds.

Inflation Risk

If the returns on mutual funds do not keep up with the rate of inflation, the purchasing power of the investment returns may be reduced. For example, if your mutual funds gain 5% in a year, but the cost of living increases by 7%, you will experience a loss in purchasing power.

Currency Risk

Currency risk applies to investments denominated in a foreign currency. If the foreign currency depreciates against the domestic currency (in this case, Canadian dollars), the investment will lose value when exchanged back.

Risk of Non-Compliance

This risk arises from the potential non-adherence to laws, regulations, rules, and internal policies and procedures by the fund manager. Non-compliance can have adverse effects on the performance of the mutual fund and, consequently, the interests of the investors.

It is important to note that not all mutual funds are susceptible to the same types of risks. For instance, equity funds are subject to market risk but provide some protection against inflation risk, while fixed-income funds face interest rate risk but offer protection against market risk. Diversifying your investment portfolio can help mitigate the overall impact of these risks.

The types of mutual funds

There are several types of mutual funds, each with its own unique characteristics and investment strategies. Here's an overview of the four broad types of mutual funds and some of their specific categories:

Equity Mutual Funds (Stocks)

Equity mutual funds primarily invest in stocks of publicly traded companies. They are often categorized based on the size and style of the companies they invest in. Examples include large-cap, mid-cap, and small-cap funds, referring to the market capitalization or value of the companies. Equity funds also include international funds, which invest in companies headquartered outside the investor's domestic market, and sector funds, which focus on specific industries such as technology or healthcare. Equity funds offer higher growth potential but also come with higher volatility and risk.

Fixed-Income Mutual Funds (Bonds)

Fixed-income mutual funds, including bond funds, are considered safer and less volatile than equity funds. They invest in government and corporate debt, providing a fixed return to investors. Examples include U.S. Treasury bond funds, municipal bond funds, corporate bond funds, and high-yield bond funds. Bond funds are suitable for investors seeking a more stable investment option with consistent returns.

Money Market Mutual Funds (Short-term Debt)

Money market mutual funds are fixed-income funds that invest in high-quality, short-term debt instruments, such as U.S. Treasurys and certificates of deposit. They are considered one of the safest types of mutual funds, offering capital preservation and liquidity. However, they typically provide lower returns compared to equity or bond funds.

Balanced or Hybrid Mutual Funds (Stocks and Bonds)

Balanced or hybrid mutual funds invest in a combination of stocks and bonds, providing diversification across asset classes. These funds maintain a fixed ratio of investments, such as 60% stocks and 40% bonds. Target-date funds are a popular type of balanced fund, adjusting their asset allocation over time to reduce risk as the investor's target date approaches.

In addition to these four broad types, there are also specialty or alternative funds, such as hedge funds, managed futures, commodities, and real estate investment trusts. Mutual funds can also be categorized as actively managed or passively managed, depending on whether they aim to outperform a specific market index or simply match its performance.

The Sampsons' investment objectives

Firstly, diversification is key to reducing the risk of loss by spreading investments across a wide range of assets. This is especially important for the Sampsons as it ensures that their savings are not dependent on the performance of a single industry or asset type. By investing in a variety of stocks, bonds, or other securities, they can reduce the impact of any one investment on their overall portfolio.

Secondly, affordability is an important consideration. Mutual funds offer a cost-effective way to invest, as they provide access to a wider variety of investments than an individual investor could typically afford. The Sampsons can benefit from economies of scale by pooling their money with other investors, reducing transaction fees and staff costs per investor. Additionally, mutual funds often have low minimum investment requirements, allowing the Sampsons to start investing with a smaller amount of money and contribute regular, small amounts to their portfolio.

Lastly, convenience and accessibility are crucial factors for the Sampsons. Mutual funds are relatively simple to invest in, especially through payroll deduction or employer-sponsored retirement plans. They also provide professional management, allowing the Sampsons to leverage the expertise of fund managers who make investment decisions based on extensive research and analysis.

In summary, the Sampsons' investment objectives should centre around diversification, affordability, and convenience. By investing in mutual funds, they can achieve a diversified portfolio with professional management, while also benefiting from cost savings and accessibility.

The pros and cons of investing in stocks vs bonds

Stocks and bonds each have their own advantages and disadvantages, and it is up to the investor to decide which option suits their financial goals. Here are some pros and cons of investing in stocks versus bonds:

Stocks

Stocks offer investors the potential for higher returns than bonds, but with higher risks. Stocks are essentially ownership stakes in publicly traded corporations, and their value can rise or fall dramatically.

Pros of Stocks:

• Higher Returns: Stocks have the potential to generate higher returns than bonds due to rising stock prices.
• Dividends: Some stocks pay dividends, which can provide extra income or be reinvested in the company to buy more shares.
• Diversification: Stocks can be a part of a diversified portfolio, offering higher long-term returns than bonds.

Cons of Stocks:

Volatile and Risky: Stocks offer no guaranteed returns and are more volatile than bonds. In the event of bankruptcy, stock owners are last in line and may lose their entire investment.

Bonds

Bonds, on the other hand, provide more stable and consistent returns, making them better suited for risk-averse investors. They are also less volatile than stocks and tend to perform well when stocks are declining.

Pros of Bonds:

• Stable and Consistent Returns: Bonds offer more reliable returns through coupon payments, and there is a guaranteed principal repayment at maturity.
• Lower Risk: Investing in debt is generally safer than investing in equity. In the case of bankruptcy, debtholders (bondholders) have priority over shareholders in the line to be paid.
• Predictable Income: Bonds offer more predictable returns, making them attractive for retirees or those seeking income stability.
• Higher Interest Rates: Bonds often provide higher interest rates than savings accounts or CDs.

Cons of Bonds:

• Lower Returns: Historically, bonds have provided lower long-term returns than stocks, typically between 4%-6% since 1928.
• Interest Rate Risk: Bond prices fluctuate with changes in interest rates, and there is a risk of reinvestment at lower yields.
• Credit Risk: There is a risk that the bond issuer will default on their loan obligations, and bonds are not FDIC-insured.

In conclusion, stocks may be more suitable for investors seeking higher returns and willing to take on greater risk. On the other hand, bonds offer more stable and predictable returns, making them attractive for risk-averse investors or those seeking income stability. A well-diversified portfolio often includes a mix of both stocks and bonds to balance risk and return potential.

Frequently asked questions