Investing in the Stock Markets

Firstly, what are unit trusts (UK) and mutual funds (US)? Well, each is a collective investment[1] - they are very similar in setup - which buys shares in companies, and then the individual investor buys shares in the unit trust or mutual fund. This allows an individual without a large amount of starting capital to invest in a greater number of shares than would otherwise be the case, spreading the risk.

The Problems With Them

One fundamental problem with them is that very few actually beat the market - namely, increase in value more than the market does - and even those that do rarely do it on a regular basis; those that do well this year are likely to do poorly next year. Individual investors also rarely beat the market and those investors that do, such as Warren Buffet, are justifiably famous. Out of thousands of mutual funds and unit trusts available to buy, only a couple of dozen may actually beat the market in any particular year.
Unit trusts and mutual funds have regular fees involved, which also come off the potential gains of the investment. These fees are the transaction costs that arise from buying and selling shares inside the trust or fund, as well as the professional fees paid to the people who actually manage the investment and choose which shares to actually buy and sell and when to do it. Given the inability most have to beat the market, this essentially mean that the investor is paying fees to professional managers just so they can underperform what the market does anyway, hardly an ideal situation.

How to Fix This

One way around this is to invest in index or tracker funds. All stock markets have a number of indices, such as the Dow Jones Industrial Average and the S&P 500 in the US and the "Footsie" or FT-SE 100 in the UK. There are many more in these markets alone, without even considering other countries. The FT-SE 100 for example consists of the 100 largest companies listed on the London Stock Exchange.
What index or tracker funds do is invest their money in all of the shares listed in that index (or sometimes a proportional representation of them) so a Footsie tracker would buy shares in all the 100 companies listed in the Footsie. The tracker fund will then do as well as the index being tracked does. This is essentially saying that the managers can't actually beat the market when doing their jobs but, as this is by and large true, it should be accepted. The trackers may not precisely mirror the performance of the index being tracked (this is known as the tracking error[2]) but it should be close enough.

With the index funds only investing in the shares in the index, management fees are less - the managers aren't doing any trading, so aren't being paid to decide what to buy and sell - and internal fees such as those generated by buying and selling shares are also less. These funds are very conservative, don't even try to beat the market and yet will still outperform most actively managed funds which, in the long run, means more money for the individual investor. Management fees or often one or two percent lower per year than those in an actively managed fund. This may not sound like a lot, but over a couple of decades an extra percent a year can make a large difference.

Choosing Your Funds

When choosing a fund to invest in, various factors should also be checked. The tracking error, as mentioned earlier, it should be as low as possible. It's unlikely to be positive, but try to keep the negative side down. Any management fees should also be checked - again, these want to be as low as possible. These also need to be checked over the longest period possible; a fund that has an average of 0.3% fees over 20 years is going to be better than one with a 0.1% fee for this year, but 0.4% per year afterwards. Ideally, the selected fund should have both a low tracking error and low fees. Which index to be tracked should also be considered; one such as the Footsie which only invests in the biggest companies will be more conservative, but less likely to see massive gains, whilst others may have greater potential gains, but greater potential risk.

An investor could get the same benefit by simply buying all the shares in the index themselves; however an investment in each of the shares in the index you want to track requires a much greater investment than investing in the unit trust or mutual fund - this is, after all, a primary benefit of these funds - the ability to invest in a wide range of shares without requiring a huge amount of capital. Any investments in a company below £1,000 or $1,000 will lose a much greater proportion of the investment in transaction fees. Investing in the dozens or, in some cases, hundreds of stocks in an index would require a cash lump sum in the tens or hundreds of thousands, which is beyond the capability of most smaller investors.

When Should You Invest?

Many unit trusts and mutual funds will allow the investor to invest on a regular basis if you don't have a lump sum. This way and amount that is far too small for normally investing in any share, say £25 per month, can still be used to start building up an investment portfolio. The ideal time to start this type of investing is now - delaying only reduces the long term gains possible. Don't wait for the market to fall to be a bargain; that isn't how a regular monthly investment works.
What an investor needs to do is to invest every month, keep investing every month and don't stop investing or reduce the amount being invested. Missing the odd investment over the years won't make a big difference; a permanent reduction in the amount being invested can dramatically reduce the value of the investment at the end. With a regular investment of this type, you don't pay any attention to what the market is doing but just keep making your payments no matter whether it goes up or down. This is very definitely a long term investment and not a get rich quick scheme, so it needs starting without delay. Investors in the UK can invest in tracker funds using a stocks and shares ISA (Individual Savings Account) which is a tax efficient means of investing money which will therefore increase the long term growth of the investment.

Diversification

In themselves, tracker funds are already quite diversified. Your investment is spread across many different shares, so that level of diversification is built into the investment. There are other ways of diversifying though. Each stock exchange, as mentioned, has different indices. You can diversify by investing in trackers that follow these different indices however a decent tracker should already have a sufficient level of diversification in its market unless you are looking to invest in specific sectors or types of shares. The other main way of diversifying is by investing in an index tracker in another country; if you are invested in the UK's All Share index you could then look to investing in a US index such as the Dow Jones Industrial Average. Investing overseas can be more expensive and require a larger investment though. In addition there can be more risk in investing in other exchanges if the markets of those countries aren't very efficient.