Investing in mutual funds is like cooking a delicious pot of chili. It’s a long-term strategy, so you have to patiently wait for the end result. And like any good recipe, you need to start with one key factor for success: the right ingredients.
Just like any other purchase you’d make, there are good financial products and there are bad financial products. When you’re getting ready to invest, you don’t want to just grab any old mutual fund off the shelf! It’s critical to understand the main types of mutual funds and pick the right ones for your investments. Let’s start by talking about five broad categories of mutual funds.
1. Equity funds
Equity funds are made up of stocks, which are publicly traded shares of a company. If you own stock in a company, you own a tiny piece of that company. When you invest in an equity mutual fund, you own a tiny piece of all the companies that mutual fund invests in. Of all the types of mutual funds, equity funds are the most volatile, but they also carry the greatest potential for growth and a higher rate of return over the long haul.
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As you learn how to invest in mutual funds, I always recommend focusing on growth stock mutual funds—which are a type of equity fund. These funds grow at a faster rate than the rest of the market. Historically, the 30-year return of the S&P 500 has been 12%.1 But if you invest in the right mutual funds, you can even beat the growth of indexes like the S&P 500. Now, that’s what I’m talking about!
You can purchase growth stock mutual funds from any broker, but the best place to start is with your retirement plan at work. Retirement savings accounts have a tax advantage, and often they also have an employer match—code for free money! If you don’t have access to a 401(k), I suggest opening a Roth IRA through an investment professional.
Growth stock mutual funds are often categorized by their cap size—or in other words, how much the companies they invest in are worth. Here’s how it breaks down:
- Small Cap Funds: Companies valued below $2 billion
- Medium Cap Funds: Companies valued between $2–10 billion
- Large Cap Funds: Companies valued at more than $10 billion
One of the most basic principles of investing is to diversify—spread out your dollars into different types of funds so that you don’t have all your eggs in one basket. That way, not all of your funds will rise and fall at the same rate. Here’s a quick overview of the right mix of mutual funds you should invest in:
Growth and Income
These are the calmest of all mutual fund types. Their goal is to provide slow and steady growth by investing in large cap companies that rise and fall much more slowly than smaller companies.
These funds invest in medium cap companies, which creates moderate growth and volatility. They sit right in between small cap and large cap funds.
These are also called “emerging market funds” or small cap funds. These “wild child” funds can make big gains and losses in a short amount of time. Aggressive funds often invest in lots of startups with the potential for rapid growth.
These are growth stock mutual funds made up of companies from around the world, and they vary by cap size depending on the fund. International funds help you further diversify your money by getting some of it outside of American companies and into companies like BMW, Mercedes and LG.
2. Bond Funds
Bond funds are another type of mutual fund where investors put their money into either government or corporate bonds. Instead of purchasing stock (or equity) in the company, you are lending your money with the expectation that you’ll be repaid. While the returns from growth stock mutual funds bounce all over the place, bond funds have a steady rate of return, which is why they’re called fixed-income funds.
This might seem like a safe and dependable investment, but let’s take a step back and remember that the goal of investing is to build wealth. Long-term government bonds have a history of yielding between 5–6%.2 But this just barely outpaces inflation, which averages between 3-4% each year.3 Even though bonds feel less risky than equity funds, you run the risk of not building enough wealth if you don’t grow your money!
3. Money Market Funds
Money market mutual funds invest in short-term debt from consumers. Most of the time, these are even worse than bond funds for building wealth! Some money market funds only yield a 3% rate of return, so your money might even lose value over time if inflation rises above 3%! That’s not okay, people! Think of a money market mutual fund as a bouncer for your money. It watches over it and keeps it safe, but it minimizes risk so much that it doesn’t leave much room for growth.
When choosing mutual funds, I coach people to avoid money market funds. Money market funds are like a forced savings plan, but similar to bonds, they’re not a great investment tool. Here’s the deal: You can’t afford to not take some risk when it comes to growing your money.
4. Balanced Funds
Balanced mutual funds (also called hybrid funds) combine investments from stocks and bonds. These funds help you automatically diversify your investments by spreading out your money. With balanced funds, you’ll commonly see the fixed ratio of 60% equity (stocks) and 40% debt (bonds).
Target-date funds are one of the most common types of balanced funds. They’re based on the asset allocation approach to retirement planning. Here’s how it works: You assume (and you know what happens when we assume . . . ) that you’ll retire at a certain age, say 65. You invest aggressively in growth stock mutual funds when you’re young but as you age, the fund automatically reallocates your investments to money markets and bonds in order to decrease volatility and risk. If you’re not careful, your target-date fund might be so conservative that inflation starts to kick your butt as you age. I recommend keeping growth stock mutual funds in your portfolio, even after you retire. Your money can still grow!
5. Specialty Funds
The list of mutual funds can go on and on, but I’m going to touch on a few of the most common types of funds here and tie up some loose ends.
Index funds are not traditional mutual funds, but they’re a close cousin of equity funds. Instead of buying stock and holding on to it, index funds operate by trading—buying and selling stock all day long. They’re not professionally managed and their goal is to “time the market” and mirror what is happening in common indexes like the S&P 500. Some investors claim that index funds are more profitable in the long run because you won’t pay management fees. But there are plenty of professionally managed mutual funds that outperform index funds consistently enough to make up for the additional fees. Plus, you’ll always benefit from working with an investment professional who is keeping an eye on your portfolio for you.
Sector funds are invested in—you guessed it—a particular sector of the economy. If you wanted to pour your money into technology, for example, you might invest in a sector fund that focuses on buying stocks from companies like Apple, Google and similar tech companies.
Socially Responsible Funds
Some mutual funds are created to especially reflect the ethical or moral views of the investor. They might invest in a wide range of companies dedicated to a certain cause—such as gender equality or environmental consciousness. They also might be deemed “ethical” by excluding products like tobacco. Each fund will yield a different return, but some are much lower than traditional mutual funds.
What Type of Mutual Fund Should I Invest In?
It takes a lot of research and understanding to get a handle on mutual funds, but it’s worth your time! Mutual funds are my favorite investing tool. If you choose the right ones, you’ll be able to build wealth, retire with dignity, and be a blessing—not a burden—to your loved ones and community by having plenty to share.
But the reality is, there are thousands of mutual funds on the market, so the best way to make your investment decisions is to work with an investment professional. Save yourself time and a whole lot of confusion by getting a trusted Pro to do the shopping for you!