What you need to know about mutual funds (1)

To be successful in investing, you must be a long-term investor. The stock and bond markets are unpredictable in the short term, but the long-term patterns of risk and reward have been shown to be sufficiently persistent to serve as the basis for long-term investment success. No matter how solid the historical record is, past experience is no guarantee of future success. However, an inquiry into the past, coupled with the common sense that makes one disciplined, is still the most reliable method a smart investor can rely on.

A long-term investment plan is bound to benefit in the future if we have a firm belief in the future and pay careful attention to the elements of investing that we can control: risk, cost and time.

In the midst of financial turmoil, gold is often seen as a refuge. As usual, the price of this precious metal rose more than three times in the 10 years from 1999-2009. But gold is a speculative commodity that is priced based on market expectations only, and there is no internal rate of return. Unlike stocks and bonds, gold cannot generate internal value; stocks can generate internal value through earnings growth and dividends; bonds can generate internal value through interest payments.

If risk refers to the possibility of not achieving a real rate of return in the long run, bonds are riskier than stocks.

By choosing a rationally balanced portfolio of stocks and bonds and holding it firmly, you can not only accumulate income but also resist adversity, whether the market rises or falls.

Long-term investors who pay the lowest costs are the most likely to earn the highest real stock market returns.

To demonstrate the shortcomings of a short-term approach to long-term investing, I will examine two common short-term strategies to show how mutual fund investors can be damaged after following suit.

The first, is market timing. That is, shifting assets from stocks to bonds or cash to avoid stock market declines, and then shifting assets from bonds or cash to stocks in an attempt to catch the subsequent stock market upturn. For most of those who follow suit, market timing tends to lead to the opposite result: being caught in the middle of a stock market decline and staying out of it when the market is high. The idea that investors should decide when to enter or when to exit based on bell cues is completely discredited. After nearly 50 years in the industry, I have yet to hear of anyone who has ever had success with this and kept it going, and I don't even know of anyone who has said this.

The second one is the high turnover rate of long-term portfolios. Obviously, mutual fund investors and fund managers are guilty of this behavior, and it is costly. Predictably, it's a lot like market timing. The behavior is based on the belief that an investor can invest in a particularly attractive stock or mutual fund, watch it rise, and then dump it when the portfolio reaches a high point. As with market timing, there is no evidence that high turnover rates improve returns for fund investors or fund managers.

On any month-to-month or even year-to-year short-term basis, the market is completely unpredictable. We should neither expect it to become predictable, nor should we make investment decisions based on impulses fueled by conventional wisdom. Whether these calls come from the headlines of authoritative publications or from our daily hopes and fears, they usually focus us on the short term and obscure our understanding of the long term.

Mr. Buffett was quick to come to the right conclusion about the state of the modern mutual fund industry when he said that an investor who does not understand the economics of a specific business but wants to be a long-term owner of American industry should invest in index funds on a regular basis. In this way, the investor who knows nothing would be able to outperform most investment experts. But the paradox is that when the slow investor admits his limitations, he is no longer slow. The long-term investor, like the tortoise in the parable, eventually wins the race against the speculator, who is like the hare that runs and stops.

The source of long-term returns is easy to explain: for the stock market, it's corporate earnings and dividends; for the bond market, it's interest payments. However, the market return is calculated before deducting the cost of investment. And to be sure, market returns do not come from speculation and frequent trading, which serve no purpose other than to transfer returns between investors. For long-term investors, investment returns are closely tied to the economic fundamentals of U.S. companies, and irrelevant to the specific process of buying and selling stocks. My view: The key to the art of mutual fund investing is simplicity and common sense.