Suitability

General suitability

The suitability of a fund, unit investment trust (UIT), or real estate investment trust (REIT) is directly related to the individual securities held in their portfolios. For example, the suitability of a large-cap stock fund is relatively the same as the suitability of a large-cap stock. The primary differences between funds/UITs and the individual securities they hold are diversification and fees.

Funds, UITs, and REITs provide instant diversification to their investors. It’s not uncommon to find dozens, if not hundreds of individual securities in a large portfolio like a mutual fund. Instead of doing the necessary research to find the best investments in the market, an investor can simply invest in a fund or UIT and have a professional invest on their behalf. This is a big benefit, especially for retail investors without the knowledge, time, or patience to invest.

Of course, investments in these portfolios are not free of cost. We learned about the expense ratio, sales charges, 12b-1 fees, management fees, and other expenses related to investing in these products. While the benefits tend to outweigh the fees for most investors, the cost of investing should be considered when choosing these investments.

Dollar cost averaging

Dollar cost averaging is a common investment strategy with investment companies, especially mutual funds. It involves an investor making a fixed dollar, consistent purchase of shares (or units) over time. Dollar cost averaging factors out market timing risk, which is the risk of putting money in the market at the wrong time.

If an investor made a $100,000 investment right before the Great Recession of 2008 (for example, in the summer of 2007), it would’ve taken over 4 years to recoup the losses from the market downturn. Investors must be aware of the risk of a market collapse soon after making an investment. The larger the investment made, the bigger the risk.

Instead of making one large $100,000 purchase, what if the investor made a $1,000 weekly investment over the course of 100 weeks (roughly 2 years)? As market prices fell, more shares were purchased with the same amount of money. This is how dollar cost averaging mitigates market timing risk. In a fluctuating market, the investor’s average cost per share is less than the average price per share. Let’s demonstrate this with an example. Assume the following purchases of ABC mutual fund occur during a market decline:

Overall, the investor purchased $4,000 of ABC mutual fund over a four-month period. During that time period, they purchased 337.5 shares. Now, let’s compare the average cost per share to the average price per share:

Average cost = $\frac{\text{Amount\hspace{0.33em}invested }}{\text{Shares purchased}}$

Average cost = $\frac{\text{\$4,000 }}{\text{337.5}}$

Average cost = $11.85

Now, average price:

Average price = $\frac{\text{Combined\hspace{0.33em}market prices at purchase}}{\text{Number of investments}}$

Average price = $\frac{\text{\$20 + \$16 + \$10 + \$8}}{\text{4}}$

Average price = $\frac{\text{\$54}}{\text{4}}$

Average price = $13.50

The average cost factors in the prices paid and the shares purchased, while average price is a simple average of the available prices at investment. In a fluctuating market, the average cost will always be lower because investors purchase more shares when the market falls. While a bear market tends to work against investors, those who continue to invest bring down their average cost of investing.