Think back to our two courses on mutual funds, Weakon 205 and 305. For a brief review, mutual funds are companies that pull investments from many people together. The advantage for the investor is access to a professional advisory, the reduction in expenses over buying your own stocks, and quick and easy diversification. I fully endorse mutual funds, and you likely have a few in your retirement account.
Well, some of the things that make mutual funds so great, can cause a downward spiral in a bear market such as our current situation. How so you ask? The value of a mutual fund is calculated at the end of each day. Let’s say the Weakonomics Mutual Fund is valued at $100 per share when an investor decides to pull his money out. An optimized mutual fund won’t have a lot of cash on hand so in order to give the investor his money, the mutual fund manager must sell some shares if stock the fund is invested in. Simple enough.
The laws of supply and demand dictate the fair value of a share of stock. Right now the is a bunch of supply (people like mutual fund managers selling), and not a lot of demand (people buying). In this scenario, the prices of stock fall. The mutual fund manager has to give the investor $100 per share. But over the course of the trading day the value of the shares he must sell takes a dive, and at the end of the day he only has $95 per share to give back to the investor. Too bad, the mutual fund company must absorb that loss and still give the investor the $100.
Now take that situation and multiply it into the billions. September saw the biggest sell-off of mutual funds since the early 2000s when Morningstar first started tracking the statistic, almost $50 billion. The linked article below says October looks to be even worse. So on top of decrease in actual value in companies, the huge increase in supply of people selling their mutual funds has further depressed the value of the stock market. Since many people look to the stock market performance as an index of our economy, you can see why we’re in this mess.
Mutual funds have it worse. Because they have to sell so much, they haven’t been able to focus their energies on taking advantage of the new values in the market. Stocks are way down, too down in my opinion. There are some good deals out there, but many mutual funds aren’t able to take advantage of them because they have no spare cash to buy the stocks. They’re stuck.
Like any business, so long as one day is up and the next day down, a mutual fund will break even or hit some profits eventually. But in the short term with these downward spirals, many mutual funds could be at risk of going out of business. Do you lose all your money when that happens? Tune in tomorrow and I’ll explain how a mutual fund goes out of business. That’s SOOO CNBC of me.
Read Morningstar
Insider Tip:
Remember “The Easiest Money You’ll Ever Make.” While many mutual funds are forced to sell, index funds should be OK. That’s because the buyers of index funds are traditionally more conservative investors. Conservative investors likely won’t sell out of fear and are willing to ride out of the market. The folks that have sold are not doing it to pay bills, they are just scared the Dow might go to 5,000 points or worse. This means they’re sitting on the cash, waiting to get back in. October is psychologically the worst month of every year for stocks, and with a depressed economy and big election coming up, people are sitting around waiting to know who will be our president. These are all psychological behaviors that have a surprising impact on the market. There exists the theory that after the election (regardless of who is elected) we’ll see a huge rally and economic recovery over the last two months of the year. Most investors that pulled out will miss this rally. The lesson, continue to invest in index funds and you’ll ride the rally, whenever it happens.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. |
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