Diversification — not putting all your eggs in one basket — is one of the most cherished principles of investing. That's one reason why mutual funds have become a popular choice for many investors' workplace retirement accounts. They're an easy way to invest in many different securities at once, and to do so at a lower cost than you might be able to achieve on your own. Though diversification alone can't guarantee a profit or prevent the possibility of loss, it can help 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. By investing in the fund, you own a small portion of each individual security. The fund's manager buys securities based on the fund's investment objective. In general, there are three basic investment objectives:
1) Growth, sometimes referred to as capital appreciation, typically means an increase in the value of your initial investment — for example, if a stock's price rises from $10 to $15.
2) Income generally refers to 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.
Types of mutual funds
Funds that invest mostly in stocks (also known as equities) often have growth as their investment objective; the fund's manager invests in stocks believed to have potential for long-term growth in share price. Within this broad category are many specific types of stock mutual funds. For example, a small-cap stock fund focuses on young, relatively 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 real estate.
Some mutual funds have a combination of objectives. For example, a balanced fund probably invests in both stocks and bonds, hoping to achieve some growth and some income. An asset allocation, lifestyle, or lifecycle fund typically invests in all three of the major asset classes; the amount of each class depends on the fund's asset allocation strategy. A basic asset allocation fund might devote a specific percentage of its assets to each type of investment — for example, 50 percent to stocks, 30 percent to bonds, and 20 percent to cash — and generally keep that allocation steady. A lifestyle fund might base its percentages on your 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 will shift its asset allocation over time, generally becoming more conservative as you get closer to your goal.
The advantages of mutual funds
In addition to diversification, mutual funds have many other advantages:
Professional money management: When you buy shares in an actively managed mutual fund, part of what you pay for is the fund manager's expertise. The manager analyzes hundreds of securities and decides what and when to buy and sell.
Liquidity: By redeeming your shares, you can easily convert your mutual fund investment into cash.
The ability to make small investments cost-effectively: By investing through your workplace retirement plan, you're able to start your account with a very small investment, and add to it regularly. That helps you keep saving. And making those regular investments through your workplace savings plan means that you won't generally owe a transaction charge on each purchase (though workplace plans may include overall plan fees, and some funds may impose a charge if you sell your shares before a certain time period has passed).
Of course, mutual funds aren't guaranteed investments. The price of all mutual fund shares can change daily, and you'll receive the current value of your shares when you sell, which may be more or less than you paid.
Note: Before investing in any mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which are discussed in the prospectus available from the fund. Read the prospectus carefully before investing. All investing involves risk, including the possible loss of principal, and there can be no assurance that any investing strategy will be successful.
Evaluating a mutual fund
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 in both bull and bear markets. A fund's prospectus must include its best and worst quarterly performance during the past 10 years.
Risks: A mutual fund involves the same types of risks as the securities it invests in. Be sure you understand the various types of risk a fund may face. 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, especially over a long time period. Find out how much you're paying to invest in a particular fund. A fund's expense ratio shows its annual costs as a percentage of its assets; some types of funds typically have higher expense ratios than others. Potential fees and expenses of your workplace savings plan's funds will likely include operating expenses that are paid from fund assets, such as fees paid to the fund's manager, 12-b1 marketing fees, and any transaction charges the fund pays when it trades individual securities.