What is a Mutual Fund?
Mutual Funds are investments that pool money from many investors and invest in a diversified portfolio of securities like stocks, bonds or short-term money market instruments. There are many different types of mutual funds. The primary objective of this diversification is to provide better returns on investment by reducing the risk associated with any one asset class.
There is an important point here: the only way to achieve this is by investing in a portfolio of securities that are not perfect substitutes for each other. By having some assets that are perfectly substitutable (like short-term Treasury Bills), you create alternate sources of return, so if one asset class underperforms (like stocks) another can help make up the difference (like money market instruments).
Then there are assets that have a little more risk than others, which might be stocks in emerging markets or smaller companies. The only way to invest in these more risky areas and still maintain overall portfolio diversification is to limit the total percentage of your portfolio invested in those sectors. Finally, there are the investments that have a significant amount of risk and in order to structure them in such a way as to be able to handle the risks involved, they would require too much capital from investors.
If you’re an individual investor, this is all pretty complicated (and boring!) stuff. The good news is that mutual funds have been structured by the professionals, and all you need to do is choose the investment that best fits your needs.
How to Choose Your Mutual Fund Investment Strategy
The easiest way to do this is by just asking yourself two questions:
First, how much risk am I looking for? That’s pretty self-explanatory (since it’s about risk). But if you’re not sure, you might want to consider asking yourself another question:
How long is my time horizon? This is where mutual funds can help. Since they’re made up of many different investments, they will have some that are designed for short term (1-2 years) and others that are meant for longer terms (5-10 years).
And by “longer term” I am not just talking about the end of your life, but also investment horizons that might be a decade or even longer. Again, it’s important to consider what time horizon you have when selecting investments because different types of mutual funds will best serve your needs depending on that time frame. Trust me – with all this talk about time, I guess it’s time to move on to the second question:
You’ve already touched on it a little bit but what are the different kinds of mutual funds? Since we’re now talking about individual investment types, I won’t go into too much detail with this one since not all investors might be looking for these investments. However, if you’d like to know more about how each of these types works, then here you go.
What is a Money Market Mutual Fund?
These are the simplest ways to “invest” your cash. However, it’s important that you understand a little bit about the risks involved with them. The general rule of thumb is that historically, money market funds have averaged returns at or slightly above inflation (or about 2%/year). This is pretty much as good as it will get with money market funds. However, there are instances when returns can be higher (because of risk-taking) but these have been extremely rare and are well outside the norm.
Money Market Funds also tend to operate on a “price” basis (where the price of investments determines their value) so they can be extremely risky during high inflationary times. And since it’s important that you understand what you’re actually purchasing when investing in these funds, there are three kinds.
Types of Money Market Mutual Funds
1-Month Cash Fund . This is a very low risk relative to other money market funds because it seeks to maintain a constant dividend rate and preserves your principal.
3-Month Cash Fund . This is slightly higher risk than cash funds but maintains a relatively low level of volatility.
2-Year Cash Fund (or Ultra Money Market Funds). This fund type carries even more risk than the 3 Month variety but also offers a potentially higher return in exchange for that risk.
What are Hybrid Mutual Funds?
Hybrid mutual funds seek to maintain a mix between the safety of bonds and the higher returns of stocks. They are essentially collections of stocks and bonds (usually with allocations that are 80% stocks and 20% bonds) and have been quite popular in recent years as they’ve provided investors with fairly high levels of return while still remaining relatively secure with very low levels of volatility.
What are Dividend Mutual Funds?
Dividend mutual funds specialize in stocks that pay out dividends, they hold a collection of investments that usually have fairly secure bonds and stocks from large, trustworthy companies within them (such as Coca-Cola). Some examples include the Vanguard Equity Income Fund , the Fidelity Equity Income Fund , and the Vanguard Dividend Appreciation Index Fund.