Learn about mutual fund in part 2 of a series. Education on what they are and how they might fit into your portfolio. Find the fund that matches your goals.
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.
You can narrow your choices by looking at your objectives:
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.
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.
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.
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.
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