Why Mutual Funds Make Sense in Today's Market

by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
June 30, 2009

Updated from the Spring 2009 issue of On Investing, a magazine for Schwab clients.

As the economy starts showing signs of recovery, investors are beginning to return to the market. But many are asking how to invest in this environment.

By "how," I mean what specific types of investments to make. Whether you are a sophisticated investor or a novice, have a big portfolio or a small one, are highly engaged or prefer to check your statement once per year, I think mutual funds make sense as an important holding in your portfolio.

Back to the future
In the financial media, the spotlight on mutual funds has been dim for many years.

Most of the wattage has been focused on "alternative" investment vehicles such as hedge funds and private equity. The bloom is off those roses, however.

A 2% management fee plus 20% of the profits on alternative investments was always a steep price to pay, but such an arrangement becomes unbearable in tough markets where hedge funds are just as susceptible to market forces as everything else.

If exotic investments aren't the answer, then what?

Given our heritage at Schwab, I have always had a soft spot for the do-it-yourself approach and believe that individual investors who make each buy or sell decision themselves can be successful.

However, that path is not right for everyone. The way I see it, there are three prerequisites to successfully managing your own portfolio. You need expertise, sufficient time and a large enough portfolio.

Expertise
Deciding which stocks and bonds to buy and sell on an ongoing basis is a skill that can be learned. If you've taken the time to educate yourself in this area, terrific! By doing so, you've cleared the first hurdle. If you haven't quite cleared that hurdle, it makes sense to use investment vehicles like mutual funds.

When you go down this path, you are, in effect, paying a professional to make those buy or sell decisions on your behalf. In return for a management fee, you get a team that has the expertise to make judgments about increasingly opaque financial statements, as well as how a particular company fits into the broader economic environment.

The expertise of mutual fund managers doesn't guarantee results, but I think most individuals will have better odds of success with professional management.

Time
Investing is a task. Like any task, doing it right requires expertise and the proper time commitment. Without both, you won't get very far.

Thanks to advances in technology and the enormous wealth of information that individuals have at their fingertips, analyzing the market, sifting through thousands of possible securities, making the right calls and monitoring your positions are more possible than ever.

At Schwab, we see knowledgeable investors who enjoy the analytical process and commit the necessary time every day. Are you one of them? If not, that doesn't mean you should stop investing.

It just means that you should consider mutual funds, where the managers and their analysts are working full time to generate returns on your behalf.

When you're a mutual fund investor, it doesn't necessarily mean you're uninvolved. It just means that you can spend your limited time evaluating the performance of your funds and deciding whether they still make sense for you.

Portfolio size
At Schwab, we spend a lot of time preaching the benefits of diversification. For example, if you want to build a bond portfolio yourself, buying a few bonds here and there (or, if you're building an equity portfolio, buying a few stocks) isn't going to cut it.

To build a well-diversified portfolio of individual bonds requires about $50,000 minimum.

If the bond portion of your portfolio is less than that, you're better off (in my opinion) with a mutual fund. Anything less and you will have a hard time building a portfolio with a sufficient number of issuers to protect yourself against the downfall of any one issuer.

The same principle applies on the equity side. There's no hard-and-fast rule here, but you'll probably need about 30 to 40 holdings to get a well-diversified portfolio of large-cap stocks. Throw in similar numbers for small-cap and international stocks and you'll see why many equity investors prefer to use mutual funds or separately managed accounts.

Selecting the right fund
While we believe most people are better off with mutual funds, you still need to pick the right funds for you. Schwab Portfolios, available at schwab.com/schwabportfolios, is a great starting point. These are complete portfolios of individual funds designed to meet the needs of different investors.

Beyond Schwab Portfolios, we also have portfolios for taxable and tax-deferred accounts, portfolios designed for smaller asset levels and portfolios that cover different levels of risk.

How can you build a portfolio of mutual funds at Schwab?

For those who prefer to build their own portfolio, Schwab's Mutual Fund OneSource Select List is available online.

Go to Schwab.com > "Research & Strategies" > "Mutual Funds" > "OneSource Select List."

It includes more than 2,000 no-load funds that meet Schwab's eligibility criteria.

If you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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