Reader question (yea i got readers): My knowledge of mutual funds would lose a game of chicken to an actual chicken, help pwwwrease.

This question comes from a friend of mine. An Average White Guy (AWG) who likes football, porno, books about war, and e-mail forwards that contain 643_fluffy_kittens.jpg. He dislikes mean things, the 2010 Philadelphia Flyers, and people who can’t wait to let you know what they know about “convertible arb hedge funds”.

Well my friend the answer you seek starts with a magnificent word called diversification. Diversification hides in the top of bell towers and straight ganks portfolio risk when it’s walking by. So it goes like this, consider you own one share in BLC (Big League Chew Inc) (ISBA: the 3 letter code there is called the “ticker symbol” or just the “ticker”. If this was too basic and you already knew that my apologies, don’t be a cock about it) and all of your money is invested in this one company because you think it’s gonna do just swell. So one day you wake up and you flick on Mildred’s Magical Morning Market Miasma to find out that it’s been discovered that the CEO of BLC has been funneling veritable oceans of company money into his crippling hooker and Faberge egg addiction for years and covering up the losses by claiming they were “loans” to a company he created called “I Hate Babies Inc.”. The stock tumbles 45%, your portfolio tumbles 45%, your retirement gets 45% lamer, and your kids resent you 45% more for having to support you in your old age. This is what’s referred to as (ISBA) “company specific risk”, “diversifiable risk”, or if you wanna super shield your ignorance “un-systematic risk”.

The idea behind diversification is to rid your portfolio of as much un-systematic risk as possible by spreading your money out over as wide a variety of investments as possible. BLC comes crashing down, that sucks, but you’re not gonna off yourself because its only 2% of your portfolio and FDP’s recent “I love babies” campaign was a huge success and they stomped Q2 earnings causing the stock to jump 6%. While this is happening your holdings in the tech sector have all taken off because the government has announced increased R&D tax breaks for these companies. So in the end your portfolio gains 1% through all of that, your retirement is now 1% better, you’re kids don’t turn bitter and stuff you in a home, and the world is all sunshine and boners once again. Now, some of you are saying “yea but if I only own one company and something awesome happens I can gain 45% in a day too!” Bro, investing isn’t a casino. Depending on how ballin, how old, how dependant you are on cash now (ISBA: your “liquidity” requirements), your ability to predict the market, amongst a bajill other things, you can juice up your risk a bit by picking higher volatility sectors or focusing more on a sector or two, but betting on one or two stocks is almost identical to lettin’er ride on black.

So you ask me “word son, but how do I get me some of this sweet sweet diversification in a cost effective manner?” The most basic way to diversify is to just buy a bunch of stocks of different companies in different industries and call it a day. However the problem with this is that unless you have a poopload of money and are investing big amounts you will be positively eaten alive by transaction costs. Transaction costs are the smelly mouth breather that drinks milk at parties of the investment world. Many an investment strategy that has looked amazing in theory has been completely de-railed by transaction costs. Transaction costs can range from about 10 bucks a trade at the dirt cheap places to upwards of 30 bucks a trade at your bank, so if you are investing 10 grand and trying to spread it out over say 10 companies (not very good diversification), a grand in each, and you are paying 20 bucks each trade, you are starting out at a -2% return already, laaaaaaaaame.

So the next option is mutual funds. Mutual funds essentially are a dude (a fund manager or manageress), deciding on a bunch of stocks to buy, and then selling you the ability to earn the return of those stocks combined….minus a tasty little bitch called the MER or management expense ratio. This is what mutual funds will charge you for the research, admin stuff, trading costs, blah blah blah and usually averages 2% annually. Mutual funds are all over the place with regards to content there are funds of small companies (ISBA: small market capitalization or small cap), which generally are higher risk higher return, funds of large stable companies with high dividends, international funds which seek to give you higher diversification than domestic only funds, etc, etc. So these little muffins give you better diversification, place your money in the hands of a professional, but still treat you like a piece of meat with holes with management fees.

A note on the “place your money in the hands of professionals” aspect of these funds…… It is the investment world’s filthy, trampy, slutty, whorish little secret that over the long term almost no mutual fund beats the market. That is, after transaction costs (remember our mouth breathing friend from above?) and management fees, almost no mutual fund will ever beat a passive (ie. Very minimal transaction costs, you buy’er and you hold’er type deal) index of stocks such as the S&P 500 (the main US index) or the S&P TSX (the main Canadian index) over more than a few years. Mutual fund companies will try and bamboozle you by cherry picking their best funds to present their results, or excluding funds that have folded due to poor performance in the past from their historical return (ISBA: this is known as selection bias). If you take anything away from this blog it is this: It is EXCEEDINGLY hard to beat the market over the long term. 95% of the people who say they can are lying to you, cheating somehow (see: Bernie Madoff), or exposing you to more risk than you are aware of. I’ll come back to this at some point in a later post.

So after that happy little thought, let’s move on to our next diversification option, my favourite; the exchange traded fund (ETF). ETFs are generally designed to mirror an index (like the S&P or TSX), a sector within an index, a commodity index (COMEX Gold index), a currency’s performance (CAD vs. USD), or even a bond index (more on bonds later). There are even ETFs that are designed to double or triple the index return (ie. The S&P goes up 2% in a day the double leveraged ETF goes up 4%), but these are poorly designed and should only used very short term by experienced peoples. ETFs are similar to mutual funds except that they actually trade on a stock exchange like the New York Stock Exchange or the Toronto Stock Exchange, have their very own little ticker guy, and aren't trying to treat your money like a red headed step child. They are designed to mirror an index period. There is still a little bit of an expense ratio, but it is for rebalancing and other admin stuff and usually in the 0.3% range, well short of a mutual fund. This, my friends, is your way to maximize your diversification while minimizing lubeless monetary sexual harassment fees.

Feel free to fire me other questions or post stuff in the comments below. I wanna know what YOU want to learn about….then insert some fart jokes in there and go to town!