In this article we’ll review the key reasons why a sound mutual fund investing strategy is essential to achieving financial freedom. Early in our journey to financial freedom, mutual fund investing can be used to grow our capital for future cash flow investments. Later in our journey, mutual fund investing can be used for income generation. And anytime in between, mutual fund investing can be used to grow and generate income in retirement accounts, college saving accounts, and more.
Learn more about mutual fund investing for financial freedom, including how to select mutual funds.
In this article:
- The Mutual Fund Investing Strategy for Financial Freedom
- Common Forms of Investing Vs Mutual Fund Investing Strategy
- How to Select Mutual Funds
- A word for new investors
The Mutual Fund Investing Strategy for Financial Freedom
Let’s first understand that financial freedom is about earning cash flow, ideally from multiple income generating assets (i.e. real estate rentals). However, we all know that acquiring these income generating assets assets generally requires start-up capital.
Therefore, in order to buy these income generating assets we need to first grow our money. This is where mutual fund investment comes into play. Mutual fund investing is part of the intermediate phase of the overall financial freedom strategy. I call this strategy the bridge to financial freedom. To learn more about the bridge to financial freedom strategy click here.
As you can see in the image above, this bridge is made out of three main components, the foundation (shown in red), the substructure (shown in yellow), and the superstructure (shown in green). The substructure component is all about saving for retirement, growing our money, and saving for college. However, mutual fund can also be part of the superstructure component. That is because mutual funds can also generate income.
Now let’s look at a practical definition of what a mutual fund is.
“A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets”
Investorpedia
It is essential to remember that when you invest in mutual funds rather than individual stocks you immediately gain diversity. Another fundamental thing to remember is that mutual funds are professionally managed to meet certain goals (i.e. capital preservation, income, growth, etc).
Although, mutual fund investing can be used to fund retirement, for cash flow at anytime, or for various other purposes, I’d like to focus on mutual fund investing for growth. Again, the idea is to use this mutual fund investing strategy as one of the three main steps to achieving financial freedom.
With this in mind, I’d like to suggest the following mutual fund investing criteria.
Small Initial Investment Amount
One of the advantages of mutual fund investing is that we can start with a relatively small amount of money. Keep in mind that if we already had tens of thousands of dollars ready to invest, then the preference would be to buy invest in other cash flowing assets (i.e. real estate).
There are numerous mutual funds that require less than $3,000 as a minimum investment. Certainly some mutual funds require huge initial investments (some require well over $1,000,000 minimums), but that’s not what we want to do here.
And to be fair, there are other paper assets such as stocks, bonds, that allow investors to get started with a small investment amount. However, as we’ll discuss below, stocks don’t provide sufficient diversity and bonds may not provide the desired returns. Mutual fund investing, on the other hand, strikes the right balance.
A 3 to 5 Year Risk Vs Return Target
When it comes to risk vs return, it is important to keep in mind that higher returns come with higher risk. For example, stocks tend to provide higher returns than bonds, but stocks also tend to be riskier investments.
Thus, to determine our risk tolerance we first need to determine what the investment time frame is. For example, if I have $1,000 to invest, but I know I’ll need $1,000 in 1 week, I may keep that money in cash even if that means I don’t make a dime.
However, if I am able to put that money towards retirement and I have 30 years before I retire, then I may be willing to invest in a technology stock. Said stock could go down a lot or could go up a lot, but in such a long time frame I don’t really have to worry about it going down for a while.
Because our goal here is to grow our investment until we have enough capital for a larger investment (i.e. investing in an online business, or real estate), then our time frame could be anywhere from 3 to 5 years, or possibly longer. Obviously, if you can only contribute $3,000 per year, your time frame would be longer than if you are able to contribute $10,000 per year.
In my view, bonds just don’t have the growth potential I’d like to see. And, individual stocks present too much risk in such a short time frame. However, most mutual funds could be a nice fit for this time-frame. They are certainly more likely to grow in this time frame than bonds. And because mutual funds provide a degree of diversification, they are likely to be less risky than individual stocks. Do you see now the importance of a good mutual fund investing strategy and why this is key to achieving financial freedom?
Dollar Cost Averaging Compatibility
Mutual funds can be bought using automatic purchases, at predetermined intervals. Think how convenient it would be to make regular contributions to your mutual fund, each pay period, after setting up automatic purchases. And when you setup regular automatic purchases you also benefit from Dollar Cost Averaging (DCA).
DCA is an investment strategy, that requires purchasing an asset (i.e. mutual funds) through periodic purchases, over a period of time.
For illustration purposes, the image below compares a lump sum investment of $8,000 to a DCA investment of the same amount. The lump sum investment is shown in blue, at January share price of $10 per share. The price per share goes up and down for a few months. And by August, the share price is $10 per share. In this case, the total gain after 8 months is 0%.
On the other hand, the orange color shows a total of eight purchases, of $1,000 each. One purchase was done at a fairly high share price of $14. However, other purchases were done at much lower prices. Thus, the average price paid in eight months is actually $9.61 per share, which translates to a total gain of 4.07%.
And that’s the power of dollar cost averaging. The beauty is our mutual fund investing strategy is fully compatible with the DCA strategy. Stock investing isn’t as compatible, because although you can setup automatic payments, every time you purchase stocks you’ll be paying a fee. That’s not necessarily the case with mutual funds.
Common Forms of Investing Vs Mutual Fund Investing Strategy
Exchange-Traded Funds (ETF) Vs Mutual Fund Investing Strategy
You may be curious about investing in Exchange-Traded Funds instead. Let’s start by looking at what an ETF is.
“An exchange–traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock. ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes.”
Investorpedia
Similarly to mutual funds, when you buy a share of an ETF you gain some diversity in your portfolio, because you are buying a basket of securities. However, ETFs are not managed to meet pre-determined goals, because they simply reflect the price of the basket of securities. For this reason, ETFs usually have lower management fees than mutual funds.
ETFs meet the two of the elements of the criteria we outlined earlier. Namely, ETFs require a small initial investment amount, they can be compatible with a 3 to 5 year risk vs return target, and dollar cost averaging can still be accomplished.
However, the fact that mutual funds are professionally managed to meet certain goals is a nice advantage. As we’ll see soon, this is particularly important, because part of the criteria to selecting mutual funds should be the fund’s objectives (goals). Being able to judge and measure the performance objectives of our investment is key to our overall mutual fund investing strategy
Finally, mutual funds are friendlier to dollar cost averaging strategies than ETFs.
Real Estate Investment Trusts (REIT) Vs Mutual Fund Investing Strategy
You may also be curious about Real Estate Investment Trusts. Again, let’s start by looking at what a REIT is.
“A REIT is a corporation, trust, or association that invests directly in real estate through properties or mortgages. They trade on a stock exchange and are bought and sold like stocks.”
Investorpedia
By definition, REITs are focused on real estate. As such, these investments do not provide as much diversification as mutual funds.
It is also important to note that to qualify as a REIT, a firm must pay out 90% of its taxable income to its shareholders in the form of dividends. Therefore, REIT’s are typically appealing to investors seeking income rather than growth. Again, our overall mutual fund investing strategy is more beneficial toward financial freedom during the growth phase.
And again, mutual funds are friendlier to dollar cost averaging strategies than REITs.
Stock Investing Vs Mutual Fund Investing Strategy
Please keep in mind that as much as I enjoy sharing about personal finance, I am not a financial advisor. Therefore, be sure to do your own research and perform proper due diligence before investing.
I started investing in mutual funds within the first few months of starting my first job. I invested in a science and technology fund, using the the dollar cost averaging method I discussed in this article. My investment grew steadily to a few thousand dollars. After that I bough a different mutual fund, which also grew steadily.
However, at some point I sold some of mutual fund shares and bought individual stocks. And then I started trading stocks in an attempt to make more money. Looking back, attempting to buy and sell stocks and trying to time the market was a mistake.
If I were doing things over, I would stick with the mutual fund investing strategy and would avoid trading stocks.
It took me years to learn that to be a successful stock trader an investor needs to be extremely disciplined and emotionally self-aware. These two traits take a level of maturity we don’t all have.
Nevertheless, my strategy of making automatic contributions to mutual funds paid off. Within two years of investing in mutual funds I was able to make a down payment on a income real estate property. This was a single family home divided into two separate units. The best part is it was cash flowing from day one.
As you can see, the mutual fund investing strategy I’ve shared here is not just theory. This is something I’ve put into practice myself and it something I’ve experienced success with, despite having made certain mistakes (like attempting to trade stocks).
How to Select Mutual Funds
Now that we understand that our bridge to financial freedom requires us to temporarily grow our capital for future larger investments, choosing the right investment is a little easier.
Unfortunately, when you start reading about mutual funds things can get a bit overwhelming. That’s because there are multiple of ways to look at mutual funds.
In fact, you’ll find there are load and no load funds, there are open and closed funds, there are equity funds, debt funds, index funds, income funds, specialty funds, tax saving funds, etc.
However, in an effort to keep things simple, I’ll focus on what I believe is most important, the overall fund’s objective. But be advised, that at some point you’ll also need to understand the fund’s valuation and expense ratios.
Mutual Funds Objectives
Mutual funds can be grouped into a few primary objectives such as capital preservation, income generation, growth and income and growth.
As the term implies, capital preservation funds do not provide growth opportunities. They are simply a place to park money and in some cases, they protect the investor from losing value due to inflation. As you may agree, this is not what we are looking for in this phase of our bridge to financial freedom strategy.
Income generation funds focus on income, such as income generated from interest or dividends. Again, this mutual fund does not focus on growth, which is what we are after.
Finally, growth funds and growth and income funds meet our overall objective.
“A growth fund is a diversified portfolio of stocks that has capital appreciation as its primary goal, with little or no dividend payouts. The portfolio mainly consists of companies with above-average growth that reinvest their earnings into expansion, acquisitions, and/or research and development (R&D)”
Investorpedia
How To Use The Morningstar Style Box
One tool often used to understand funds is the Morningstar Style Box (See the bottom half of the illustration below). This Morningstar Style Box attempts to illustrate a fund’s objective.
On the horizontal axis, the Morningstar Style Box shows whether a fund is primarily focused on value, growth, or both (blend). On the vertical axes, the Morningstar Style Box shows whether a fund is primarily focused on small cap, mid cap, or large cap investments.
In the image below I drew two arrows on the side of the Morningstar Style Box. These arrows indicate that risk increases from left to right (or from value to growth) and from top to bottom (or from large cap to small cap). In other words, the top left box is the least risky and the bottom right box is the riskiest.
For our purposes, mutual funds that invest in small cap companies may be too risky. But as we discussed before, this all depends on the investor’s time frame and appetite for risk.
If I were starting to grow my investments, and given a 3 to 5 year time frame, I would focus on the upper right side of the Morningstar Style Box, as illustrated in the graph below. In my opinion this quadrant provides good potential for growth, yet it isn’t as risky. However, always keep in mind we all have different levels of risk tolerance.
Understanding PE Ratios
The price to earnings ratio (PE ratio) is calculated by dividing the price per share of a given security, by its earnings per share. However, it is easiest to just look for the ratio rather than calculating them.
The lower the PE ratio, the better. Thus, the PE ratio can be used to quickly compare similar stocks and mutual funds. Keep in mind that valuations (and PE ratios) can be very different between investment industries.
For example, high tech stocks will typically have higher valuations than utilities stocks. This is because investors purchasing high tech stocks generally expect the earnings of those stocks to be higher in the future than in the present time. Thus, investors are willing to pay more for a stock they feel will have future higher earnings.
Utility stocks on the other hand don’t have such expectation. Consequently, utility stocks tend to have lower valuations (lower PE ratios).
Comparing Mutual Funds Expense Ratios
Some mutual funds get a little creative to try to sound like they don’t have fees. The best way to compare the cost of owning a mutual fund to another is by utilizing the expense ratio.
From a mathematical point of view, the lower the expense ratio, the better. However, keep in mind that sometimes higher expense ratios can be justified by better mutual fund objective performance.
Armed with this knowledge, you can now spend some time on a site like Morningstar to look for mutual funds that meet your criteria. The fund below in the image below is something I picked for illustration purposes only.
Researching Mutual Fund Holdings
Becoming familiar with the mutual fund’s portfolio (asset allocation and holdings) isn’t as important, provided the investor is comfortable with the mutual fund’s objectives. However, I like to look at the top 10 holdings of mutual funds I am considering. Fund managers are experts, so I find it interesting to look at what they think are good stocks.
Where to Get Mutual Fund Information
As you’ve probably noticed already, I tend to use Morningstar.com as a place to start. If nothing else, the site is mostly free and I find it familiar and consistent. This website is particularly useful when trying to filter out good mutual funds.
However, the ultimate place to look for information on a given mutual fund is the actual fund’s prospectus. A mutual fund prospectus is a document detailing the fund’s objectives, strategies, costs, etc. These can be obtained directly from their corresponding mutual fund companies.
A Word For New Investors
I recently had the opportunity to provide some financial guidance to a young man who was about to start his first job out of college. This young man has a bright future ahead of him. Among other things, he is very financially intelligent. He has no debt and is already planning to start contributing towards retirement.
However, I was a little surprised that he had not thought about saving money outside of retirement in the manner I’ve described above. In his mind, saving for retirement through 401Ks, Roth IRAs, and such was enough. And perhaps that’s enough, if your goal is to work until age 60+ and then live off of what you saved.
But, that’s not freedom! And after I explained the idea of using mutual fund investing, for financial freedom, to my young friend he fully understood the concept. The idea is to save money that can be easily accessible (outside of retirement accounts), to grow that money, and to later purchase cash flow producing assets. The cash flow from those assets is what provides freedom.
And by the way, this doesn’t mean we have to retire from a job we enjoy. We can still work, but we would do so because we choose to do so and not because we depend on a check from our employer.
Moving Forward
If you don’t have an account where you can implement this mutual fund investing strategy for financial freedom, I’d like to encourage you to open one this week. If you already have one, but are not taking advantage of dollar-cost averaging strategies, I’d like to encourage you to do so today.
And last, to learn more about the bridge to financial freedom strategy click here.
If this article has helped you in any way. Please consider that you can also help others by posting a comment in the section below. In addition, you can also follow me on Twitter at @Cash_Keen
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