The challenging investment environment of 2008 taught many of us a painful but valuable lesson — it pays to know where you invest your money and whether that strategy is suitable for your circumstances. Many people rely on mutual funds, preferring that professional managers make day-to-day trading decisions. While this approach may make sense for you and take some of the complexity out of investing, it does not let you off the hook when it comes to understanding where you put your money. A mutual fund is merely your conduit to the stock and bond markets, not an alternative to it. A fund is made up of individual securities that will include stocks, bonds and cash investments.
At the most basic level, mutual funds can be broken down into three categories:
These invest primarily in equities of companies, either in the U.S. or overseas. There are a wide variety of stock funds, ranging from index funds that own a representative percentage of stocks in the market, to sector-specific funds that focus on a particular type of company, such as technology or natural resource stocks. With a stock fund, you are investing in the expectation of future earnings power of the company. Most of the return will be the result of changes in stock prices.
These are funds that essentially invest in IOUs. Bonds are a form of credit offered by investors to bond issuers. For instance, government entities finance their debt by issuing bonds. Corporations do the same thing. The return to investors comes mostly from the yield bonds generate, but a bond can fluctuate in value and be worth more or less than its face value if it is sold before reaching the maturity date. That is why bond funds can change in price as well, though typically, not as dramatically as is the case with stock funds.
Money Market Funds
Investors seeking to keep money in a cash-equivalent investment will turn to money market funds. These are funds invested mostly in very short-term securities issued by government entities, banks and corporations. Most individuals who put money to work in a money market fund are looking first and foremost for a safe place to keep a portion of their liquid assets. The return is typically quite low, but that is the tradeoff for the corresponding level of risk. Money market mutual funds are generally designed to maintain a stable net asset value of $1 per share (though there is no guarantee that a fund will do so). The only variability that should occur with this type of fund is the amount of interest it pays to shareholders.
Finding the right investments
After you have decided your investment strategy, the next challenge is to determine what is right for your circumstances. Factors that come into play include the time you have to let your investments work before reaching your goals and your tolerance for risk. Be aware that the more aggressive your risk tolerance is, the more volatile your portfolio is likely to be in the short term.
To help you sort through the thousands of fund options, there are ways to simplify the process. One is to choose a “fund of funds,” a mutual fund that invests in other funds that typically seek to achieve a specific investment objective. Find a fund in this category that suits what you are trying to accomplish in your portfolio. Another simple alternative is to select “target date” funds. In this case, you choose a fund that is managed toward an objective of a specific year that coincides with your own goal.
Once you’ve decided which type of mutual fund is right for you, it is time to do some homework. You need to understand the fund’s investment strategy and accompanying risks and learn about the fund’s management by reading the prospectus, which describes the fund’s objective and the strategy used to achieve it. Be sure to read the quarterly, semi-annual and annual reports to see the actual fund holdings to make sure you are comfortable with the investments the managers are making, and the size of those investments as a percentage of your entire portfolio. If you have several mutual funds with prominent positions in one particular company, you could be less diversified than you had planned to be.
Now more than ever, each dollar matters and you have an obligation to understand and be comfortable with the investments you select. A financial advisor can help you determine appropriate investment strategies that are right for you.
An investment in money market funds is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to maintain the value of your investment at $1 per share, it is possible to lose money by investing in the Fund.
There are risks associated with an investment in a bond fund, including credit risk, interest rate risk and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
Investment products, including shares of mutual funds, are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involved investment risks including possible loss of principal and fluctuation in value.
“Fund of funds” and “target date funds” are comprised of holdings in several different funds, which may include small-cap, mid-cap, large-cap, money market, international, bond, and/or sector funds. Each of the underlying funds in which the portfolio invests has its own investment risks, and those risks can affect the value of each portfolio’s shares and investments.
This information is provided for informational purposes only and is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor.
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