Avoid that dreaded all-your-eggs-in-one-basket cliché and look to a bin of mutual funds for diversification.
So you want to build a robust retirement portfolio that avoids the dreaded all-your-eggs-in-one-basket cliché? Consider mutual funds one choice for portfolio diversification.
By pooling funds with thousands of others, investors can spread their risk across a wide variety of investments that may shield a portfolio from the pitfalls of a market collapse or the risks of an all-out recession.
Wait, what? A tried-and-true method to always beat the markets? Nice try, but no: mutual funds are not fool-proof. Remember, these are the markets you’re dealing with, and there are no guarantees of profits or prevention of losses. Ever.
But mutual fund investing has become a valuable tool for individual investors who are seeking a way to hold a wide range of stocks, bonds, or other securities that might otherwise be prohibitive because of costs. Funds can be an effective way to jump on the big-cap bandwagon, for example, without fear of falling off on the first bump. One fund can carry hundreds of underlying securities, allowing investors to achieve some portfolio diversification.
The minimum initial investment in a fund can be small compared to building a diversified portfolio stock by stock. What’s more, funds can let you tackle an active investment management strategy across a broad range of asset classes without having to actually activate a brainwave. There’s a management team for that.
Now, it’s still important to consider costs when choosing mutual funds. Some are actively managed, meaning there’s a group of professionals working to select securities, time the markets, and rebalance the fund. Passive funds are typically index funds with a portfolio manager who tracks an index, such as the S&P 500.
The cost differences can appear small—average expense ratios on active funds are about 1.5%, while they’re only 0.25% on index funds. Over time, however, that small gap can add up. Consider a $10,000 investment in an index fund, earning 8% annually, for example. This hypothetical scenario would deliver $93,347 after 10 years. Compare that with the same parameters on an active fund, and the return stands at $63,944—almost $30,000 less.
Like the people who own them, retirement portfolios come in all shapes and sizes, no matter how they’re built and funded. Mutual funds do, too. There are funds that invest in just big-cap stocks or just international equities. Some invest in bonds, or stocks and bonds, or stocks and bonds and hybrids like convertible and preferred securities. Other funds put money into emerging growth companies. If you can dream it, they can mutual-fund it. And then you can invest in a whole slew of funds that have nothing to do with each other. You get the picture, and you can see it in detail on the mutual funds screener at tdameritrade.com.
Suppose, for example, you want to see how many funds are available through TD Ameritrade that carry Morningstar Ratings. Create a custom screen, check those boxes, and 13,434 matches will pop up. Filter the search to those that are open to new investors and have no transaction fees, and the number drops to 3,691 matches. Refine it further by noting that you only want socially responsible funds, and the matches fall to a more manageable 104 choices. Open those matches, and the screen will define the asset class, the minimum investment, and other important information that you can use to narrow down the list.
Not sure you’re drawn to those funds? Save the screen and create a new one with different attributes. The combinations aren’t exactly infinite, but let's just say there are plenty of choices.
Wrap your head around this, too: In 2015, there was a whopping $15.7 trillion—yes, with a “t”—of U.S. net assets in mutual funds alone, according to the Investment Company Institute.
Asset allocations and time horizons are two of the fundamental keys to proper portfolio diversification and strategy. But sometimes, it’s risk tolerance that can dictate the other two. Are you willing to chance high-risk ventures for high returns? Or would you prefer a steady-as-she-goes glide into retirement? Some investors refer to it as the “sleep at night” quotient: What range of risk keeps you awake in fear that your portfolio will lose a lot of its value?
Many professionals might tell you to consider the time horizon when addressing the risk factor. If you’re in or nearing retirement, for example, the rule of thumb is to stick close to your knitting and hold large-cap value funds or fixed-income assets with steady growth that stays ahead of inflation. But for young investors with a long time horizon, a little more risk now could pay off in 30 or 40 years.
Here’s what different portfolios might look like for separate levels of risk tolerance:
Try to avoid combining funds that hold similar stocks, like a small-cap value and a small-cap blend, because that could create more risk. Investors are likely to find more diversification among funds that have large-cap value and small-cap growth stocks, for example.
As with any portfolio investment, you must carefully consider objectives, risks, charges, and expenses when investing in mutual funds. And remember this about mutual funds: You don’t actually own shares of the equities or bonds in the fund; you own a piece of the fund itself.
Log in to tdameritrade.com, point to Research & Ideas, and under Screeners, click Mutual Funds to start a search.
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