Choosing a Mutual Fund - Guide to Mutual Fund Investment

Index Funds

This is an interesting type of fund that has attracted a good deal of attention of late, positive as well as critical. You may see them as stable, long-term winners or as underachievers by design, depending on your perspective. Index funds try to match the rate of return of major indices, such as the Dow Jones Industrials. So, for instance, if the Dow is earning 10% a year, an index fund manager will select a portfolio of Dow Jones stocks designed to match that return.

Good Fit: This is a great choice if you’d be satisfied with matching how major barometers of the market are doing (in addition to the Dow Jones, there are a number of other index funds which track and mirror other indices). There are certainly worse places to put your money, what with the way major indices have performed in 1998 and 1999. In fact, in recent years, index funds as a group have outperformed other types of funds, which argues for going with the flow rather than buying and selling a great deal in hopes of beating the rest of the market. Another plus since index funds tend to buy and hold more than other funds, they also have lower operating expenses, which puts more of their returns in your pocket.

Bad Fit: Many investors and financial pros argue that it’s absurd to just match what the overall market is doing why not try doing better? There are plenty of funds that are doing just that. So if you fall into that category or are simply more aggressive by nature, an index fund may drive you up a wall. And, in down markets, index funds will likely follow the tide and drop as well. By contrast, other sorts of mutual funds may be able to buck the downward trend.

International Funds

These funds, like index funds, have gotten a lot of attention of late, primarily because, as the U.S. stock markets continue to hit dizzying heights, investors are looking to other places to invest where a lot of upside potential exists. Basically, international funds invest in companies that are located outside the United States. Some funds may pay attention to companies in so-called emerging growth areas (countries that, while historically underdeveloped, are beginning to advance economically), while others may also mix in bonds from overseas companies and governments.

Good Fit: International funds may well be an aggressive investor’s Mecca. Many are highly speculative and promise substantial returns, given that many such developing companies and regions are forecast to experience remarkable growth. Best if used for long-term holding in hopes of riding out volatility, particularly when balanced with more stable funds.

Bad Fit: The conservative investor’s nightmare. While the return potential may be super, so are the risks. For instance, political instability such as the potential overthrow of the ruling government isn’t exactly a day-to-day concern for most U.S. companies. In contrast, for many foreign companies, who happens to be running the political show on that particular day is a very real issue. Add economic uncertainty to political, and your international fund may offer you one wild ride. Not for the timid.

Growth and Income Funds

These are something of a hybrid. On the one hand, such funds usually invest in growth companies, mirroring the aggressive philosophy of the first four funds we’ve discussed. However, growth and income funds also put a portion of their money into more stable investments, such as established stocks that pay a large dividend (these are income paid by investments, which investors can reinvest or take from a fund in the form of cash). In that sense, the funds can also be a more conservative source of regular income.

Good Fit: Growth and Income funds are, overall, definitely more conservative than the other funds we’ve covered. In that sense, they’re suitable for investors who worry about losing money and prefer to avoid taking extreme risks in hopes of landing a big return. These funds can also provide a nice balance when mixed with more aggressive types of funds.

Bad Fit: Not for the investor who’s willing to risk some volatility. And a mix solely of growth and income funds may be simply too conservative for the investor with a long-term outlook. With a big chunk of time, many investors can afford to be more risky.

Sector Funds

These funds invest in stocks within a particular industry or economic sector, such as high technology, health care, or utilities. By concentrating their stock purchases, sector-fund managers hope to score big if the industry as a whole does well. But the opposite side of the coin is equally true. Should an industry fare poorly or be out of favor with the investment community, sector funds can take a big hit.

Good Fit: Sector funds are akin to hopping a ride on a bucking bronco. If you stay aboard, you can score big points, but there’s an equal chance of your being tossed off and landing on your butt. Sector funds are suited to investors who are willing to ride out the ups and downs, particularly if they offset sector funds’ risk with more stable types of funds.

Bad Fit: Just about everybody else. Many financial pros argue that sector funds contradict the basic principle of diversification by sticking to one industry. Others contend that the only investors who belong in sector funds are people with a firsthand knowledge of the sector the fund is investing in, such as a banker who invests in a financial services fund. If you don’t know an industry backward and forward, some say, investing in a sector fund is little more than a crapshoot

Needless to say, there are many more types of mutual funds, but this gives you a basic overview of some of the major players. Most of the other mutual funds you’ll encounter will likely be some sort of subsection of these broad categories.