Investing in Mutual Funds
What kinds of mutual funds are there?
There are mutual funds to suit every investor's needs, each with a predetermined investment objective that specifies what types of investments are made and what investment strategies are pursued. Funds vary widely in the risk to return ratio, and it is important to understand that risk and reward are directly related - the higher the potential return, the higher level of risk that is assumed.
Funds typically invest in stocks, bonds and short-term money market instruments, and may target certain geographic regions, company types (small cap or large cap, for example), industries or sectors of the economy. Funds may invest according to particular investments strategies, for example value or growth. They may be actively managed, meaning that the managers select securities on the basis of the value they are believed to add to the portfolio, or passively managed, meaning that the fund is created to replicate the performance of an index, for example, the S&P 500.
How will I know what type of mutual fund is right for me?
Investment decisions are highly personal, and are based on many factors that include your individual financial goals, your time horizon, your tolerance for risk and your financial circumstances. It's a good idea to sit down with your financial advisor and talk about some of these issues.
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Financial Goals: It is particularly important to give your financial advisor an accurate picture of what you would like to achieve financially, and what types of issues are important to you. Do you need to generate income in the present, or are you concerned with growing your assets to fund your retirement? Do you have a child's college education to prepare for? Would you like to purchase a second home? These are all important issues to be considered. Generally, the longer your investment horizon, or the time until you will need to realize income from your portfolio, the larger your allocation can be to growth-oriented stock investments. If you need your money in the near future, you will want to make a larger allocation to less volatile securities like bonds. If you need liquidity in the nearest term, you will want to consider money market instruments.
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Risk tolerance: Understanding your relationship to risk is an essential component in successful investing, and it is critical to understand how risk and return are related in order to develop appropriate expectations. If you are highly uncomfortable with sharp fluctuations in value, for example, an aggressive growth fund is likely not right for you. If you hope to achieve a return in excess of 10% and have a long time horizon, you should develop a willingness to assume more risk in your portfolio. Over the long term, security prices are typically determined by corporate earnings. However, in the short term emotion can influence the market. In a bull market investors tend to ignore risk, while in a bear market long term opportunities are often ignored.
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Financial circumstances: Your personal situation, income, assets, tax status and family structure, as well as many other factors, all influence your investment choices. Be sure that you thoroughly discuss these circumstances with your financial advisor.
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