Diversification is one of the most cherished principles of investing. I long for a better phrase than “don’t put all your eggs in one basket,” but it tells the diversification story in a nutshell. That’s one of the reasons why mutual funds and EFTs (exchange traded funds) are a good choice for many. You can invest in many different securities at once, and you can do so at a lower cost than you might be able to using hundreds of individual securities. Though diversification alone cannot guarantee a profit or prevent the possibility of loss, it can minimize how much your portfolio is affected by the problems of a single company or borrower.
The basics of mutual funds
A mutual fund pools the money of many investors to purchase securities such as stocks or bonds. It can focus broadly, like on large US companies, or with a fine point, such as small tech companies in India. By investing in a fund, you own a small portion of each individual security. The fund’s manager buys securities based on the stated investment objective. In general, there are three basic investment objectives:
1) Growth, sometimes referred to as capital appreciation, means the goal is to increase the value of your initial investment through stock price increases –for example, when a stock’s price rises from $10 to $25.
2) Income generally means the goal is to receive regular payments of interest (generally paid by bonds) or dividends (generally paid by stocks).
3) Capital preservation is the objective of investments whose most important goal is to protect the value of your investment (your capital) rather than increasing the value of that investment over time. The focus is on safety rather than growth.
Types of funds
Funds that invest mostly in stocks (also called equities) often have growth as their investment objective: the fund invests in stocks believed to have the potential for long-term growth in share price. Within this broad category are many specific types of stock mutual funds and ETFs. For example, a small-cap stock fund focuses on younger small companies that are expected to grow faster than average; a large-cap fund would typically invest in larger, more stable companies.
Bond funds are made up of debt instruments that governments or corporations issue to raise capital; they typically seek current income. Bond funds are generally classified by the type of issuer in its portfolio (for example, a government bond fund would focus on U.S. Treasuries and debt issued by federal agencies); by the term of the bonds it holds (e.g., a short-term bond fund might hold bonds due in 1-2 years); or by a combination (i.e., an intermediate-term corporate bond fund). Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.
Money market funds are aimed at capital preservation. A money market fund holds extremely short-term debt and is often used as a place to put money temporarily until you decide whether and how to invest it elsewhere. A money market fund tries to protect the value of your initial investment by keeping its share price at $1. However, there is no guarantee it will always do so, and it is possible to lose money in a money market fund.
An index fund attempts to match the performance of an index, such as the Standard & Poor’s 500 stock index, as closely as possible by holding the same securities used by the index.
A sector fund generally focuses on a specific industry, such as biotechnology or artificial intelligence or real estate.
Some funds have a combination of objectives. For example, a balanced fund invests in both stocks and bonds, hoping to achieve some growth and some income. A “target date” or “lifecycle” fund typically invests in all three of the major asset classes (stocks, bonds, and cash equivalents); the amount of each class depends on the asset allocation strategy. A lifestyle fund might base its percentages on risk tolerance; a conservative fund would likely focus on stability and/or income, while an aggressive fund would typically pursue growth/capital appreciation. A lifecycle fund shifts its asset allocation over time, generally becoming more conservative as you get closer to retirement.
The advantages of funds
In addition to diversification, mutual funds have other advantages:
Professional money management: When you buy shares in a fund, part of what you pay for is the expertise or strategy. A manager can analyze hundreds of securities and decide what and when to buy and sell.
Liquidity: By redeeming your shares, you can easily convert your mutual fund investment into cash.
Cost-effectiveness: The ability to make small investments go much further, to hold hundreds of companies’ securities with one investment. You can start your account small and add to it regularly.
Of course, funds are not guaranteed investments. The price of all mutual fund shares changes daily, just like stocks, and you’ll receive the current value of your shares when you sell, which may be more or less than you paid.
Evaluating a mutual fund
Long-term performance/returns: A fund’s prospectus must include historical performance figures and compare them to an appropriate benchmark index. Consider how a fund has performed over the long term, in both bull and bear markets. A fund’s prospectus must include its best and worst quarterly performance during the past 10 years.
Manager commitment: Do the fund’s managers invest their own money in the funds? Research shows that the ones who do invest in their own funds do better than those that don’t. It seems like common sense, investing alongside the managers who are also in it.
Risks: A mutual fund involves the same types of risks as the securities it invests in. Be sure to understand the various types of risk. In addition to the risks faced by all mutual funds, such as market risk, a fund may involve risks that are specific to the underlying investments. For example, a global stock fund may face currency risk (potential loss from changing currency values); a bond fund faces default risk (the possibility that bond issuers might default on a loan) and interest rate risk (rising interest rates could affect the fund’s share price). Such risks cannot be eliminated by diversification alone.
Fees and expenses: Investing costs can have a substantial impact on your net returns. Low expenses often helps a better return in the end. A fund’s “expense ratio” shows its annual costs as a percentage of its assets; some funds have higher expense ratios than others.