Editor’s note: This is part 2 of a multi-part primer on what mutual funds are and how they might fit into your portfolio. Part 1 introduced mutual funds—the basic structure, terminology, and why you might choose to invest in them.
Many financial advisors view mutual funds as one path for new investors to jump into the markets and a way to accomplish portfolio diversification.
But how do you go about choosing a fund? At the end of 2016, the Investment Company Institute, which tracks and researches mutual funds, said there were 16,344 domestic mutual funds holding more than $19.21 trillion in assets. Yep, that’s a lot of choices, but there’s a method to the madness of finding what might suit you.
What Are Your Objectives?
You can narrow your choices by looking at your objectives:
- Investment goal. What is the purpose of your investment, i.e., for what are you investing? Are you targeting wealth accumulation, income needs, preservation of capital, speculation, or a mix?
- Time horizon. How long do you plan to be in the market—in other words, how old are you, and are you investing for retirement or some other, shorter-term goal?
- Risk tolerance. Some call this the “sleep-at-night quotient.” If you’re the type who breaks out in a cold sweat over every oscillation in the markets, your resilience to risk might be as pliable as a dead twig on a tree.
The Three Are Intertwined
Your risk tolerance should be balanced with your short- and/or long-term goals and your age, or really, how much time you have ahead of you before you need to tap into funds for various life stages like buying a home, raising children, or retiring comfortably.
In general, experts say that the younger the investor, the more risk tolerance you typically see investors take on. The idea is that you have time to overcome any dip in wealth accumulation that might occur, such as a recession. As you age, financial professionals prescribe a more moderate to conservative approach when retirement is just around the corner.
Some Funds Are Targeted; Some are Broad
Many well-diversified portfolios contain a mix of domestic and foreign stocks and may contain both equity and fixed-income in their asset allocation. But you can also find money market funds and specialty funds, or just fixed-income or sector funds. It’s often said that if you can dream it, there’s a mutual fund for it.
A typical equity fund may be grouped by a stock’s market capitalization, which would broadly be clustered under small-, mid-, and large-cap stocks. They can include stocks in any number of securities.
Small-cap stocks generally refer to those with market capitalizations of $2 billion or less, suggesting that they offer the highest risk and return potential, while mid-caps fall in the $4 billion to $10 billion range, with slightly lower risk and return. Those in the $10 billion and above category, large-cap stocks, tend to be more mature, and established companies that carry less risk, although that isn’t always the case.
Some mutual funds are based on growth stocks—those with more risk, which are considered more aggressive—or on value stocks, or on stocks with a past that has been more financially stable and likely to offer dividends. You might like to consider those alternatives. Other funds lump them together for blended or hybrid funds.
And the Top 7 Types Are …
What goes into a fund’s portfolio depends on a number of factors, including the fund manager’s professional opinion on which combination might outperform the markets. But as we pointed out in part 1, the manager must stay within the confines of the prospectus, a document covering the specifics of the fund.
- Money market funds. Considered among the safest (read: less risky/lower return) types, these are usually invested in cash and cash-equivalent securities like Treasury bills, certificates of deposit, and bank debt.
- Fixed-income funds. These are generally government-backed Treasury bonds, notes, and bills, as well as corporate bonds, which are backed by particular companies that are expected to pay interest on a fixed schedule.
- Equity funds. These are tied to stocks and will vary from growth to value stocks and everything in between.
- Balanced funds. Just like it sounds, a hybrid mix of equities and fixed-income securities.
- Index funds. Popular now, these seek to mimic the return profile of specific market indices like the S&P 500 or the Russell 2000.
- Specialty funds. These focus on specific domains such as socially responsible securities, real estate, or commodities.
- Fund-of-funds. Yes, there are funds that invest in other funds.
The point is, with mutual funds, you have choices. And if you’d like to further narrow your choice set, in the next installment of this series, we’ll consider the effects of taxes and fees on fund performance. The bottom line? They’re not all the same.
Choice Is Opportunity
TD Ameritrade offers a variety of account types and investment products to fit your needs.