Many investors have a false sense of safety when they invest in mutual funds. Therefore, they do not like them. Or if you lost a lot of money investing in mutual funds, you may even hate them. But are you aware of the common misunderstanding about investing in mutual funds?

You can get a few clear advantages from investing in mutual funds. It is less time consuming and your risks are more diversified than with investing in individual stocks. If you want to invest in the stock market, but you do not want to invest in mutual funds, you often resort to investing in individual funds (there are also Index Funds, but that is a topic for another article). However, how do you pick the right individual stocks?

Stock Picking

The most common approach is that you do your homework. You analyze the financial numbers of many different companies, you read the reports from analysts and you try to pick the long term winners. You review these companies every quarter to make sure that you are still betting on the right stocks.

Another option is to subscribe to a stock picking service and trust that the seller gives you the best advice. Both approaches have the same limitations:

1. Ten thousands of professional and amateur stock pickers are doing the same thing as you and are reviewing every day the financial numbers, strategies and opportunities for all those companies out there.

   All their knowledge and conclusions are incorporated in the current stock price. Will you find something that they have overlooked and that gives you an edge to pick the right stocks that will do best?
    

2. Sometimes markets are going down. And during recessions and bear markets almost all stocks are going down in price; the poor companies and the good companies. This overall market movement can turn the buying and selling of stocks of great companies into loss making ventures.

Thus investing in individual stocks and stock picking are not very attractive alternatives for rational and cautious investors who want to invest their savings in a profitable way. And it is especially not attractive when you do not want to take too much risk or spend too much of your time on managing your investments.

False Sense of Safety

As said before, when stock markets fall, almost all stocks fall. This is the basis behind the misunderstanding around mutual funds. Many investors have this false sense of safety when they invest in mutual funds. I have made this mistake before as well. You count on these funds to be safe investments since they are professionally managed.

Here is the misunderstanding. The fund managers are expected to invest the majority of the money that they manage in the stock market. And this is what they are doing. They invest the majority of your money both in good times and in bad times. In good times they try to pick the biggest winners. And in difficult times they try to pick the companies that do better than the rest.

When the overall market is going up, the fund manager competes with ten thousands others to try to identify the biggest gainers. Few fund managers will do better than the average market. This is not ideal, but it hurts less. The market is going up and everybody makes money.

It is another story when the overall market is falling. When the overall market is going down for a prolonged period, almost all stocks are following this down trend. Some do better than the others. But also these stocks are in general going down in value when the overall stock market index is going down for a period of months or years. Thus, if you or the funds you own have invested in these stocks, you may do better than the average, but you are still losing a lot of money.

But why do fund managers invest your money then when markets are falling? Because it is their job! They invest money in funds and they do the best they can. If they would not invest your money, you could just as well sell the fund and put all your money on your savings account. And that is what fund managers want to avoid.

Time the Market

Mutual funds and index funds offer you the advantages that you do not need to pick the best stocks yourself and that you diversify your risks over many different companies in a very simple and economic way. But you cannot rely on just putting your money in these funds and trust that they always will make money for you.

Your solution to this situation is to buy index funds and mutual funds at the beginning or during the time that the overall market is going up for a prolonged period. And similarly, you sell the funds that you own at the beginning of a period that is characterized by a long term trend downwards.

This is simple, but how do you do this? Make sure you have objective trend indicators. Read our introduction letter to our fellow investors.