Mutual funds 101

There are said to be three types of people when it comes to finances. There are spenders, who seek immediate gratification; savers, characterized by their willingness to delay gratification for safety and security; and finally, there are investors, those who seek financial independence.

According to financial adviser Francisco Colayco, most Filipinos do not have a strong savings culture and thus belong to the first category. However, most of the savers do not have the necessary financial knowledge to graduate to become investors. While becoming a saver is a huge improvement from just being a spender, the traditional savings methods may no longer be applicable or even dangerous today. Let me explain.

For most of Pinoys, parking their money in banks is good enough. After all, those steel vaults guarded by stern looking men make people feel safer about their money than if it’s just kept inside a hallow bamboo or a cardboard cylinders with plastic covers.

There’s also this perceived incentive that by keeping money in banks, the money grows due to interest. But what people don't realize is that despite the additions being made in their passbooks, they're actually losing money since the interests offered by most banks are not enough to stave off inflation.

Most banks offer a per annum interest rate between 1 and 2.5 percent depending on the amount a person deposits. For time deposits or certificate of deposits, probably the preferred savings tool by most Filipinos, the interest rates usually ranges from 2.5 to 3.5 percent. The problem with this is that annual inflation rate is usually higher than these rates. For example, inflation watchers considered 2007 a good year because the rise of the prices ranged only between 2.6 and 3.1 percent.

Those who have their money in time deposit probably feel that they are adequately protected from inflation given the said figures. But is 0.4 percent increase on one's saving really that much of an incentive to keep your money in a bank? Also for a person to avail of a 3.5 percent interest rate, he should have at least P1 million deposited. That means for non-millionaires, losses in banks are a reality. Although their money appears to be increasing, the opposite is actually happening

Sure a few pesos here and there doesn't hurt that much given the benign inflation numbers. But if inflation rates suddenly shoot up (which does happen), it will eat into people's savings. To guard against inflation, one must find a way to have his money grow faster than the rate it is shrinking. One way of fighting inflation is by starting a business. But for those who do not have the necessary entrepreneurial qualities, a mutual fund may be the best way to go.

An introduction to mutual funds
Let me say first that I was not paid by any mutual fund company to write this stuff. This really is a sincere effort on my part to let others know about this thingamajig. Now that that's out of the way let me introduce you to the amazing world of mutual funds.

I don't want to sound like one of those people hawking their products in a home TV shopping program but amazing really is an appropriate word to describe this investment tool. Consider this:

In 2004 the American mutual funds industry was estimated to be worth over a $7 trillion participated in by 10,000 companies and 83 million investors. In the same year, the Philippine mutual funds industry was estimated to be worth a paltry P54.95 billion with just 25 companies handling the funds.

Yes, the Philippines is a smaller and less economically developed country than the US and so it's natural that this huge discrepancy between the number of mutual funds investors exists. However, the huge number of Americans who have availed of mutual funds also shows that it is a widely accepted investment instrument there.

Since the mutual fund industry here is underdeveloped, it has a huge potential for growth and it really is amazing what this bodes for people who would be willing to avail of it.

I hope that got your attention. So what are mutual funds really? As its name suggests, a mutual fund is an instrument that allows that allows people to pool their money together for a specific investment objective. It is managed by a professional investor who determines how best to invest the money into particular securities.

To tell truth, I just got that from the net and the first time I read that definition I still did not understand what a mutual fund is because of the word "securities." So here's a definition: securities are any form of ownership that can be easily traded on a secondary market, such as stocks or bonds. And what are stocks and bonds? Stocks are a share of ownership in a company while bonds are proof that a company or the government owes you something. Simply put, stocks make you a part-owner of a company, while bonds make you a lender to a company or the government. How a mutual fund is invested into these two instruments determines its classification. The three most common types are equity funds (primarily in stocks), bond funds, and balanced funds (equally invested in both stocks and bonds).

If all that stuff still sounds too technical, here's a more simpler way of looking at it. One can look at mutual funds as a type of business that provides money to other companies by either becoming part-owners or by loaning money to them. Profit is earned from this set-up when a company experiences growth (equity funds) or after a firm starts paying the interest of the loan (bond funds).

In deciding to invest in mutual funds, it is important what to know how much risk you are willing to take. Equity funds offer the highest returns but also come with the greatest risks. Bond funds are not as risky but the returns are lower. For people who are middle of the road risk takers, balanced funds are the most popular option due to the protection offered by equal exposure to both markets (down markets for stocks usually means an up market for bonds and vice versa).

Advantages of mutual funds

1. Mutual fund investing is putting into practice the common investment saying "Never put your eggs in one basket."

Mutual funds offer instant diversification, a requirement if you plan to play the stock or bond market. There is a need to diversify in investing in these to markets to lower your risk, because there is a larger chance of failure if you are tied to one company.

For example you have P100,000 savings and you decided to invest it all on PLDT shares priced at P1000 per share. The next day a military group attempts another power grab and to succeed they thought it necessary to destroy PLDT transmitters in Southern and Northern Luzon. In doing so PLDT shares plummet to P200 per share. Congratulations. You just lost P80,000 of your savings.

If you had instead put that money in an equity fund that is invested in PLDT, San Miguel, ABS-CBN, and Maynilad you might have done better. The principle of course is that different industries do not move in the same direction together. A good day for one company may be an excellent day for another or a really bad one for another.

The example I gave is a really bad one because such an event would normally cause the price of publicly traded shares to plunge but stay with me here a little longer. Just remember that having your funds tied to just one company is a really a bad investment strategy.

2. It is cheap
Normally, if a person wants to make it big in the stock market, that person has to either be very lucky or very rich.

Lucky because, a little luck really is needed in any form venture and rich because money is needed to make sure you don’t rely too much on luck by lessening the risks through spreading your investment.

To invest in a number of companies successfully though, it has been said that a few million is needed which a lot of people do not have. This exclusivity is broken by mutual fund companies by pooling together the resources of individual investors, who would otherwise be unable to invest effectively in the stock market, and using that consolidated fund.

For as low as P5,000 a person can invest in mutual funds and need only P1,000 more for subsequent investments.

3. It is managed by experts
Stock markets around the world are littered by names of bankrupt people who thought that they can do a better job than professional investors and failed. There have been exceptions of course but is it really wise to tempt fate when your money, and possibly future, is involved?

To track your investments, one must have time and the expertise to study all details to help you determine whether a company is worth your money investing in. Then you must relay these pieces of information to your brokers who would then try to procure for you your desired stocks or bonds. In short, a tedious process. So if you have a regular job, this is not advisable unless you want to get fired.

Mutual fund companies simplify this procedure. You give your money to a company. They give it to a manager, who is professionally trained to decide which investments are the best ones. After some time they inform you how much your investment is doing.

I really hate sounding like those home TV shopping people but really, it’s that easy.

Read, read, read
A lot of people were recently duped into investing in pyramid scams so it’s understandable for people to be wary of another investment tool promising riches.

So I advise that you not just believe what I said here but read up on these things so you can judge for yourself the reliability of mutual funds. About.com, part of the New York Times Companies, for example has a Business and Finance section which gives an overview of mutual funds. Inquirer.net has also tackled mutual funds repeatedly through the blog of business page editor Salve Duplito. And for good measure, I am also including an article by former socioeconomic secretary Romulo Neri advocating mutual funds.

Hopefully this has been an interesting read and encourages you to try out investing in mutual funds.