Today, there are thousands of mutual funds on the market. With several fund categories designed to meet virtually every possible investment objective, the choices seem endless. So, how do you narrow down such a vast selection? Most investment professionals recommend taking a logical approach to finding an investment that best meets your needs.
Here are some frequently asked questions about mutual funds:
Why Invest in Mutual Funds?
A mutual fund is an investment company that pools the money of many individuals and institutions and invests it on their behalf. Mutual funds can invest in stocks, bonds, options, futures, currencies, money markets, or just about any other security that exists.
You may ask, "Why not invest in these securities directly?" Mutual funds offer investors many advantages that individual securities do not:
Professional Money Management
Most people do not have the time, expertise, or resources to choose and manage individual securities. Professional managers have a full-time commitment to their investment responsibilities, a wealth of financial research, economic information from various resources, and the experience and skill to identify, select, and manage their portfolios.
With mutual funds, you can create a balanced investment portfolio that may help to reduce risk—compared to that of individual securities—and that may perform during volatile markets. Mutual funds, by nature, are diversified because their portfolio managers will typically invest in anywhere from a few dozen to hundreds of different securities. Even a concentrated fund will be more diversified than the average individual who invests in just a few stocks or bonds. Diversification also means not only investing in different asset classes (e.g., stocks, bonds, cash), but different types of holdings or sectors (e.g., technology, retail, or health care industries) within asset classes.
Mutual funds have given many more people access to investing in the financial markets because of their low minimum investment amounts and transaction costs (as compared to individual securities). Additionally, mutual funds can offer immediate access to your money via the telephone or Internet. Many convenient features, such as systematic withdrawal plans, automatic reinvestment, and record keeping services are often available as well. While mutual funds offer investors many benefits, it's important to remember that they do not come without risks.
Risks of owning mutual fund shares include:
The value of your shares will increase or decrease depending on market conditions.
You can lose your money, and mutual funds have no Federal Deposit Insurance Corporation (FDIC) insurance like bank accounts.
Objective not met
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There is no guarantee that a fund will meet its investment objective.
What Are Your Investment Goals and How Long Will It Take to Achieve Them?
When choosing a mutual fund, you first need to identify the reason(s) you are investing. Do you want to finance your child's college education? Are you saving money for your heirs? Perhaps you're dreaming of a comfortable retirement or even an early retirement. Your goals may be just around the corner or a long way off. This timeframe is known as your investment time horizon. Your time horizon will play a large part in determining how to best achieve your goals.
For example, if your investment time horizon is less than five years, you probably should choose more conservative investments, like money market funds or dividend-producing bond funds, to help you achieve your goal. If, on the other hand, your time horizon is greater than 10 years, you may want to choose more aggressive investments that carry more risks, but with potentially higher returns, like stock funds.
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How Much Risk Can You Bear?
Risk comes in many forms, but the main risk you face when investing in mutual funds is that your investment will lose money. Once you have an investment time horizon in mind, you will be in a better position to assess your risk tolerance level. In general, the longer you have to invest for your goals, the more risk you'll probably be able to bear. Conversely, if your time horizon is short, you'll most likely want to invest conservatively.
Time horizon is not the only factor in figuring out your risk tolerance level. You should also consider your age, income, expenses, tax situation, liquidity needs, and your investing personality. Financial markets can make some investors queasy, while others don't get the least bit flustered! Determining your risk tolerance is a very personal process. Your investment professional can help you work through this process.
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Equity or Income...What's the Objective?
The two most general investment types are equity and income. Mutual funds and other securities are classified using these terms because they basically identify the investment goal.
Equity, in a broad financial sense, means owning interest in a corporation through its common and/or preferred stocks. (By owning stocks, investors help companies raise capital.) By investing in common and/or preferred stocks, equity mutual funds often seek to produce capital appreciation. Often referred to as growth or aggressive growth funds, equity funds tend to carry a higher level of risk and potential returns than more conservative investments. However, there are degrees of risk within various equity sub-categories (e.g., small-cap stocks are riskier and more volatile than large-cap stocks).
In most cases, the primary objective of income mutual funds is to produce current income using bonds, including government, mortgage-backed, municipal, and international bonds. Income mutual funds are often qualified with a secondary objective of either income with safety of principal (less risk), or income with the opportunity for growth (more risk). Income funds generally carry a lower degree of risk than equity funds.
Some investors prefer a combination of equity and income as an investment objective. Equity and income funds invest primarily in common stocks of companies with a history of capital gains, while maintaining consistent dividend payments. Investors with this objective should consider the total return on their investment, which includes both income and capital appreciation, instead of separating equity and income objectives.
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Which Funds Match Your Objectives?
Identifying the mutual funds that have the greatest potential to meet your investment objectives is no easy task, especially given the large number of funds that may fall into a specific objective category. For example, small-cap, mid-cap, large-cap, index, and concentrated funds may all be included within the equity category.
It's important to compare the fund's risk level to your own tolerance. Each fund carries a certain level of risk in its respective category. To see how our Funds stack up, take a look at the Risk/Reward Spectrum within each Fund overview. You should also attempt to align a fund's investment objective to yours. For example, a small-cap equity fund may be ideal if your objective is long-term growth of capital, while a government bond fund with objectives of income and preservation of capital may not fit your needs.
There are also several independent mutual fund information services, like MorningStar, Lipper & Company, and Value Line, which can assist you in determining risk levels and investment objectives. When consulting such services, however, be aware of the criteria that are used in rankings. Though performance is important, other key factors to consider include the fund's management, turnover rate, and investment approach.
Most importantly, read the prospectuses to get in-depth information on fund objectives, fees and expenses, investment strategy, portfolio holdings, and complete risk disclosure.
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How Much Emphasis Should Be Placed on Performance and Costs?
For many investors, performance is the end-all in choosing a mutual fund. Though it is an important consideration, it's critical that you keep performance in perspective. A fund's successful record of growth is a positive indicator, but it is not a guarantee that growth will continue in the future. As you review a fund's performance, look for consistent above-average returns for the past three, five, and 10 years. If your time horizon is long, look at performance records for a similar length of time.
Also compare fund performance against its benchmark index. For example, performance for a mid-cap equity fund can be compared to the Standard & Poor's Mid Cap 400 Index1.
Additionally, a fund's fees and expenses will play a role in choosing a mutual fund. Some funds have a front-end load, which is assessed when you buy shares, and others impose a contingent deferred sales charge, a back-end load assessed when you sell shares before a certain period of time. In general, the lower the expenses, the greater the return to the investor versus a similar investment with higher expenses. However, if you've found a fund that has consistently strong performance, matches your objective and risk tolerance, but has a front-end load, you may still want to consider investing in that fund over the long term. Sales charges can be complex, especially if you're considering multiple funds, and it makes sense to consult your investment professional for assistance.
Once again, please read the prospectuses for complete information about fund performance, as well as fees and expenses.
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