Mutual Fund Investing
When implemented properly, mutual fund investing can be key to a sound financial freedom strategy. Early in our journey to financial freedom, mutual fund investing can be used to grow our capital for future cash flow investments. Later on, 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.
In this article:
The game plan of mutual fund investing for financial freedom
Determining an investing criteria
Mutual funds vs Exchange-Traded Funds (ETF)
A word for new investors
My experience with stocks and mutual funds and the overall financial freedom strategy
The Game Plan of Mutual Fund Investing for Financial Freedom
“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
One more thing worth noting before we get going, is that mutual funds are professionally managed to meet certain goals (i.e. capital preservation, income, growth, etc).
The bridge to financial freedom strategy entails achieving financial freedom by earning cash flow from multiple investments. However, we all know that buying cash flowing assets requires start-up capital, which also requires financial stability.
Therefore, in order to buy those cash flowing 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 bridge to financial freedom, or the substructure of the bridge.
In short, constructing the substructure of the bridge to financial freedom involves saving for retirement, growing our investment, and saving for college. And mutual fund investing can be applied to each one of those areas.
Determining an Investing Criteria
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. The idea is to investing for growth to later be able to fund larger cash flowing investments.
Nevertheless, the information shared here can also be used for income generation purposes. With this in mind, I’d like to suggest the following starting criteria.
Small initial investment amount
A 3 to 5 year risk vs return target
Dollar cost averaging compatibility
Small Initial Investment
The assumption here is that we have a relatively small amount in savings. When it comes to small initial investments, paper assets (such as stocks, bonds, and mutual funds) can all meet this requirement. 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.
If we had tens of thousands of dollars ready to invest, then we’d want to be buying cash flowing assets (i.e. real estate). There are numerous mutual funds that require less than $3,000 as a minimum investment.
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.
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%.
Source: www.luckscout.com/
And that’s the power of dollar cost averaging.
Mutual Funds Vs Exchange-Traded Funds (ETF)
You may be curious about investing in Exchange-Traded Funds instead. Let’s start by looking at what an ETF is.
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. As such, ETFs have lower fees.
ETFs meet 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).
Finally, mutual funds are friendlier to dollar cost averaging strategies than ETFs.
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.
My Experience with Stocks and Mutual Funds and the Overall Financial Freedom 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 mutual funds 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 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).
Looking Forward
If you don’t have an account where you can buy mutual funds, outside of your retirement account, 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.