Mutual Fund Investment Guide

About the Mutual Fund Guide

In this guide, we cover the basics of mutual fund investing: equity and bond funds and why an investor would choose them; the differences between balanced, index, and specialty funds; exchange traded funds; mutual funds for each age group and how to evaluate historical performance; and money market funds. While this guide provides an overview and general advice, we encourage you to seek the advice of a qualified financial advisor in order to receive specific information about your individual financial situation.

In many ways, mutual funds level the playing field for individual investors. Mutual funds allow even the least interested and least educated investors to participate in the stock market in an effort to increase personal wealth and retirement savings. Mutual funds offer a rather inexpensive way for almost everyone to take advantage of the skills and experience of professional money managers. But some of the specifics of mutual funds can be confusing. And, even though they provide almost instant diversification, mutual funds are not without risks.

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To see anwsers to the most common mutual fund questions, visit the Mutual Funds FAQ.

Equity and Bond Mutual Funds

Equity funds are great for growth and capital appreciation. Bond funds provide income and capital preservation. The two main categories of equity funds are growth and value. Each has a place in an investor's portfolio because they focus on different companies.

Growth funds hold stocks of companies that are poised to grow significantly. These are usually younger companies whose growth rate might be increasing by double digits each year. Growth stocks don't usually pay dividends, so the only way an investor can capitalize on these stocks is to have them appreciate. But investors often pay for high growth, which means these stocks can appreciate quickly. Value funds focus on the stocks of older, more established companies that are trading a price lower than the intrinsic value of the company. The stocks in a value fund are purchased because they usually pay dividends and because the fund manager believes they will appreciate once the market realizes the price of the stock is too low.

Bond funds provide income. The fund can specialize in U.S. Treasuries or corporate, municipal, or high-yield bonds. U.S. Treasuries funds should really only be considered by retired investors, while high-yield bond funds should only be considered by younger investors who can withstand a loss of principal.

For more details, visit the Equity and Bond Funds page.

Balanced, Index, and Specialty Funds

Balanced funds hold a mixture of stocks and bonds. The fund manager attempts to offset the volatility inherent in each market by holding both investments. Stocks and bonds rarely move up or down in tandem. Therefore, a balanced fund is able to smooth out the risks of each market. Unlike funds that are more actively managed, balanced funds tend to have a lower cost of ownership and are more tax-efficient.

Index funds are very widely held. They're almost always offered as part of an employer-sponsored retirement plan. They work by simply tracking a market index. The fund holds all of the stocks in the same amounts and weightings as the index itself. The expense ratio is extremely low because there is no active management of the fund. Since so few actively managed funds actually beat the S&P 500 each year, index funds are a truly cost-effective and efficient way for investors to participate in the market.

Specialty funds are actively managed funds that specialize in one sector, industry, country, or other specific area. While specialty funds can increase returns of the entire portfolio dramatically, they can also drag it down with significant losses. For example, with an index fund, even if one entire sector is down, several other sectors may be up. With a specialty fund, if one stock within the fund is down, chances are they'll all be down as similar stocks trade in similar ways. Specialty funds can also have high expense ratios and can trigger large taxable events. Fund managers often turn stocks over very frequently within a specialty fund. Fund owners then are responsible for the taxes that are due on the gains. Specialty funds certainly have a place in a portfolio, but be very careful when purchasing one. Make sure you understand the risks and make sure your returns won't be significantly affected by the tax implications.

For more details, visit the Balanced, Index, and Specialty Funds page.

Exchange Traded Funds

Let's face it. ETFs are fun. They offer the diversification of mutual funds with the trading excitement of stocks. The cost of ownership is less than that of mutual funds and they're extremely tax-efficient. Investors can trade indices, currencies, futures, commodities, and almost every kind of specialty investment imaginable.

One of the biggest advantages of ETFs by far is the lower expense ratio. For example, an index mutual fund might charge expenses of just under 1% per year. An ETF, however, might charge just 0.4%. The difference might not seem like much, but over time, the difference in expenses means less money in your pocket and less available to compound. Add to this the fact that most brokerage houses charge less to buy and sell ETFs than mutual funds, and their advantages become hard to ignore.

Investors and traders both appreciate the tax efficiencies of ETFs. If you like to trade as well as invest, ETFs can be a great way to boost returns. ETF managers are able to exchange stocks held within the ETF rather than sell them. This allows for a more favorable tax treatment. Traders then are able to control when a taxable event is triggered. Reducing the amount of taxes that are due with each trade enables a trader to keep more of the earnings.

For more details, visit the Exchange Traded Funds page.

Best Mutual Funds and Performance

Finding the best mutual fund for your age and level of risk tolerance is not always easy. Younger investors are wise to focus on aggressive growth funds, but are often not sure if that should be in the form of a small cap fund or emerging market fund. Older investors, especially those who need to generate income from their investments, know they also need to protect assets from losses. They might have trouble deciding between a balanced fund and a straight income fund.

One thing to remember regardless of your age: risk isn't always about losing principal. It also involves choosing investments that don't perform as you need them to according to your financial goals. In other words, a U.S. Treasuries bond fund presents little risk in terms of loss of capital. But for a younger investor, it presents the risk of inadequate capital appreciation.

If you're unsure about the amount of risk you should be taking, an asset allocation fund may be the right type of fund for you, at least for a large portion of your savings. Asset allocation funds come in many forms but all are diversified funds that hold stocks, bonds, precious metals, real estate, and cash-equivalents. This diversity of investments spreads the risk of loss over all asset classes and lessens the risk of catastrophic loss.

For more details, visit the Best Mutual Funds page.

Money Market Funds

Money market funds are one of the best places to "park" short-term savings. Money market funds invest in U.S. Treasuries, corporate bonds and paper, and tax-exempt municipal bonds. Money market funds should not be confused with money market demand accounts that are offered by banks as a kind of super-charged checking account. Money market funds are true mutual funds. They are professionally managed investment products. As such, they are not FDIC insured.

While U.S. Treasuries and general money market funds are well-suited to all investors, tax-exempt funds work well for high-income investors, those who live in highly taxed states, and those who need to reduce their taxable investment income. Tax-exempt funds invest in municipal bonds and are always free from federal tax. In most cases, the income generated is also free from state and local taxes as well.

Mutual fund investors have many options when it comes to choosing the right funds. Whether you're a young investor just starting out or a seasoned investor nearing retirement, there's a mutual fund or two that will help you achieve your investment goals. Just be sure to always read the prospectus and analyze a fund's historical performance. All mutual fund companies must provide a prospectus upon purchase, but it's value is largely wasted unless you read it before investing.

For more details, visit the Money Market Funds page.

While we've covered the basics of mutual fund investing here, there is much more to maximizing the success of your fund investment strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

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