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How to Pick a Mutual Fund – Type

Most of the assets in American mutual f funds are domestic stocks.  However, there are funds for every conceivable type of asset class.  There are also a variety of investment objectives and asset allocations.  Picking the type of mutual fund that is right for your financial situation is no easy chore, especially for the novice investor.  So, I have provided a basic run-down of the options available and their investment characteristics. 

This is the third in a series of five posts on mutual funds.

Why I Invest in Mutual Funds
How to Pick a Mutual Fund – Return
How to Pick a Mutual Fund – Type
How to Pick a Mutual Fund – Fees
How to Pick a Mutual Fund – Risk 

Disclaimer: I’m not an investment professional nor am I licensed to sell securities.  This information is provided for entertainment purposes.  Before investing, you should seek the advice of an investment professional.  I’m not affiliated with nor do I receive compensation from mutual fund companies. 

Asset Classes

Old Stock Certificate

Image by BombMan

Stocks – Stocks are considered an equity investment, because they represent partial ownership in a company.  They are volatile and can gain and lose value rapidly.  They are most suitable for investors looking for growth who can tolerate risk, such as younger investors.  They are not suitable for investors looking to preserve capital, such as retirees and near retirees. 

Because of the twin crashes of 2001 and 2008, this has been a lost decade for stocks.  However, stocks are historically the best performing asset class, over a long period of time.  Stocks are valued based on earnings, so if the companies’ earnings grow, their stock values will increase.  Also, many stocks pay dividends, which increase the return and provide income. 

Bonds – Bonds are considered income investments, because they pay interest to the bond holder.  They have more stable prices than stocks, which makes them suitable for people living on investment income.   They are better protected from bankruptcy than stocks.  And some bonds, such as municipal bonds, have tax advantages. 

One thing you have to worry about with bonds is rising interest rates and inflation.  If you own a bond paying 4% interest and inflation jumps or new bonds are issued at a higher rate, the value of your bond will drop.  Bonds can also appreciate if interest rates drop.  But, interest rates are close to zero right now, so that is unlikely to happen.  I’m not experienced in bond investing, so I will defer to others who are more knowledgeable. 

Real Estate – Real Estate funds (and their counterpart REITs) invest in properties, which are considered a real asset.  Real assets are considered an inflation hedge, because the value of the asset usually appreciates as prices go up.  Real estate also has an advantage in that it can generate cash flow from rents and the sale of properties. 

Despite the real estate crash, RE funds and REITs remain popular for investors because of the dividends.  I’m definitely no expert, but I am leery of real estate right now.  Even through residential real estate has fallen dramatically; I think we are far from the bottom.  The reason I say this is because real wages have been flat for years and the value of housing is based on qualified buyers.  Now that no-doc loans are gone, so are many of the qualified buyers.  Commercial real estate is a potential disaster.  I could envision a large contraction in retail and office space, even after the economy recovers.  Consumers and companies are wising up to this costly way of doing business in huge buildings.

Precious Metals – Precious metals are also considered a real asset and an inflation hedge.  Some metals, such as gold and platinum, have far outpaced most other investments over the last decade.  This investment is suitable for anyone looking to preserve capital and is recommended by most financial experts for a portion of your portfolio. 

I remember back in 1980, when my parents cashed in their silver at the height of the market for $20 per ounce.  Thirty years later, silver is trading around $15.  The point I wanted to make is that precious metals are simply a store of value.  Their intrinsic values can change based on demand and scarcity.  But, they don’t benefit from earnings and cash flow from rent or operations.  That’s why I don’t believe the breath-taking performance of gold will continue, unless inflation rises or the dollar drops significantly.  Once again, I’m no expert in precious metals.  I was completely wrong about gold exceeding $1,000 per ounce.  So, I’m probably not the person to ask. 

Money Markets – Money markets are considered a financial (paper) asset.  They are similar to other interest based investments, such as savings accounts and CDs.  They are suitable for risk averse investors, who are looking to preserve capital and can accept a low rate of return. 

Back in the ’80s, when they were returning 10%, money market funds were very popular.  I had one and my money seemed to be growing rapidly.  In reality, inflation was eroding my fund assets just as fast.  Now that interest rates are close to zero, money market funds aren’t so popular.  Why pay a management fee for an investment that pays very little interest?  It doesn’t make any sense.  No-fee money market funds are starting to appear. 

Investment Objective

The investment objective has a lot to do with your goals and demographics.  If you are young and looking to accumulate assets, you are probably suited for Growth investing.  If you are approaching retirement, you would probably want to take a Balanced approach.  If you are retired and need the cash flow from your investments, you are probably suited for Income investing.

Growth Earnings are expected to grow faster than the market
Value Trades at a lower price than earnings or assets justify
Income Seeks payment from dividends, interest or capital gains
Balanced Seeks a combination of growth, income & preservation

Some of America’s most successful investors, such as Benjamin Graham and Warren Buffet, have focused on Value investing.  This is a proven strategy of finding stocks that are undervalued and waiting for them to appreciate.  Value investing takes a lot of time and patience.  There can be long periods when the market is over-valued and there aren’t many bargains to be found.  But, for disciplined investors, a value strategy can be very lucrative.

Active vs. Passive

One of the biggest arguments among fund investors (and finance bloggers) is whether you should choose active or passive management.  Active management means a fund manager chooses the stocks for a fund and they usually charge higher fees for this service.  Passive management means the fund manager buys a fixed set of stocks (usually tracking an Index like the S&P 500) and stays with them.  There are many credible arguments for passive index investing, including lower fees and turnover.  I recommend Index funds for people who aren’t confident picking a mutual fund.

Why I don’t invest in Index Funds.

I’m going to voice an opinion right here that may not be popular.  But, I have a duty to my readers, so I’m going to tell it like it is.  I’m not a big fan of passive index investing.  First, it’s been way too easy for me to pick actively managed funds that beat the indexes, including the increased fees.  Second, there are many laggard and dinosaur stocks in the indexes, which I would prefer to not own.  Third, I suspect the flood of new index investors caused a bubble in these stocks, which wasn’t supported by their earnings.  That’s why indexes such as the S&P 500 have been hammered lately.  It’s the same thing that happened to NASDAQ stocks after the dotcom bust.  I first witnessed this phenomenon when I owned shares of the Janus Twenty fund.  Money pouring into this popular fund shot the twenty stocks into the stratosphere.  Then, they came crashing back to earth.

Stock value is ultimately based on earnings.  Anything else is speculation. 

Market Capitalization

The size of a company, based on its outstanding stock value is called market capitalization.  This is calculated by taking the number of outstanding shares times the current share price.

Small Cap Less than $2 Billion
Mid Cap Between $2-10 Billion
Large Cap More than $10 Billion

The reason market cap is important for investors to understand is because these stocks generally behave in different ways.  Small Cap stocks have the best average growth rates.  But, they are also the most volatile and risky.  Large Cap stocks offer greater stability, but, their growth is slower.  Mid Cap stocks have become popular, because they offer some growth and stability.

Another important thing to know about is the popularity shift.  During boom times in the market, Small Cap stocks are hot, because they are growing quickly.  During market downturns, there is a “flight to quality”, which means people start moving their money into the more stable Large Caps.

Domestic vs. International

Domestic Securities from Your Country
International Securities from Other Countries
Global Securities from Your Country & Other Countries
Emerging Securities from Growing Countries

I recommend holding at least 25% of your portfolio in foreign funds.  This helps to protect against regional stock market panics and currency fluctuations.  The real question is, how much risk should you take with your international holdings?  Should you invest in large multinational companies for the stability?  Or, should you invest in emerging countries for the growth prospects?  That depends on your risk tolerance and investment objectives.

Sector Funds

These funds invest in specialized areas of the economy, such as medical, technology, finance and manufacturing.  They are offered to investors as a way to choose industries that may outpace the general economy.  Mutual fund companies like to show off their latest hot sector fund as an example of their earnings prowess.  But, if you check the returns on all of their sector funds, often two thirds of them are under-performing the market.

Being a long-term investor, I avoid sector funds.  The hot sectors change so fast that I don’t like keeping up with them.  And, the institutional investors are likely to beat you to the punch.  I learned my lesson with home builder and uranium mining stocks.  The whole point of owning a mutual fund is to have a well-diversified portfolio of stocks.  Sector funds are a risky gamble.

Asset Allocation

Most financial experts recommend a mix of stocks, bonds and precious metals in your portfolio.  This can protect you if one asset class crashes.  Also, different allocations are recommended for different investors.  As someone nears retirement, they should increase the percentage of bonds and precious metals and decrease the percentage of stocks.  This protects your portfolio from market crashes and inflation.  It also adds stability.

There are Asset Allocation funds that do this for you automatically.  All you have to do is to choose the fund with the right time horizon and the fund manager does the rest.  For example, if you plan to retire in 2032, you can pick a fund that allocates your investments based on that maturity date.

The Bottom Line

The bottom line is that there are thousands of combinations of fund types and most won’t be suitable for your investment objectives.  So, pick the types of funds that support your investment goals and ignore the rest.

“Wide diversification is only required when investors do not understand what they are doing.”

Warren Buffet – American Billionaire Investor

Recommended Reading

Invest it Wisely – How to Invest in Vanguard Funds Using ETFs
Len Penzo – REITs: A TIERed Investment for Dyslexics
Balance Junkie – Are Money Market Funds a Good Place to Park your Cash?

14 comments to How to Pick a Mutual Fund – Type

  • You’ve provided a thorough look at investing with this series. This is a great resource for anyone who’s just starting out, or looking to refine their current approach. Thanks!
    Balance Junkie recently posted..20 Cents from August 2010My Profile

  • This is really a fabulous investing primer and series.These are definitely important concepts to keep in mind as we decide and implement our investing strategies.
    Roshawn @ Watson Inc recently posted..Job Security vs Independence- Yakezie Round Up- Uncommon Money NewsMy Profile

    • Thanks Shawn and 2 Cents.

      I hope it’s not too comprehensive for some readers. But, there is a lot of ground to cover on this subject. I will probably turn this into a reference in the future.

  • Great post, Bret. I am also leery of real estate as a capital investment, though I think it could still be fine as a rental property. Interest rates also don’t have much room to go anywhere but up, so I would be a little wary of bonds for the same reason.

    About precious metals, you are entirely right: They are an insurance policy and a store of value. Who would have ever thought that gold would have shot up the way it did since 2000 or so? What a great investment that would have been! As for the future, it’s not as clear. Gold does not pay dividends or income, so there is more of a risk of price fluctuations.

    I find your position on index funds to be very interesting. Is your strategy to go with actively managed funds that invest in the entire market? I would like to know more about what you think about the active vs. passive debate.
    Kevin@InvestItWisely recently posted..Consumer Ethics and Animals- Where Do You Draw the LineMy Profile

    • Kevin,

      I’m saving right now for a rental property. The problem is that SFRs are still almost a half mil in San Clemente. So, there is no way you can rent them out. If they come down into the low threes, I’m on one. I’m also thinking about senior housing, since it’s more affordable and rents well in our area.

      Precious metals are puzzling to me. They should keep pace with the true rate of inflation at around 4%, but they are far outpacing that. There aren’t any big supply or demand issues, so I suspect a speculative bubble. I hear rumors a lot of the gold funds don’t hold any real gold. They are just riding futures. I’ll bet Jennifer Barry from LiveRichly would know more about this.

      If you read the Buffet quote, you know I’m not trying to cover the market. My strategy is to target areas I think will outperform. I didn’t tip this in the post, because I want people to choose for themselves. I have Mid Cap Value, Capital Appreciation, Small Cap and International funds. I don’t hold bonds or PMs. That’s pretty aggressive for my age, but my risk tolerance is very high. I’m looking to cash in on a recovery. If it doesn’t come, we’ll have bigger problems than our investments.

      • Hi Bret,

        Other types of investments have outperformed precious metals over the long run, but there are times (like the past 10 years) where precious metals go on fire. I believe they serve best as an insurance policy, especially in uncertain times as we are seeing today.

        Unlike other types of investments, gold cannot vanish into thin air. One does have to be careful about “paper gold” vs. real gold, and I like that you brought that point up. I don’t know if it’s worth keeping everything in physical, but having some might not be a bd idea.

        I think there is value to doing some research and investing based on that, but isn’t it interesting how well passive funds do with little effort? I am not really convinced on paying another guy to try and beat the market when few are able to do this consistently, but I think if you do your own research and due diligence, you might succeed!

        Finally, I agree with you when it comes to doom & gloom. I invest based on the idea that the world doesn’t crash & burn in the next 5 years. If it does, will it matter that I lost my equity? We will probably have more pressing things to worry about, and your real assets in that case will be your connections, your health, and your skills & knowledge!
        Invest It Wisely recently posted..Weekend Reading- Labour Day Weekend EditionMy Profile

      • Hi Bret, hope you are enjoying your holiday weekend! I could write a book about gold but I will spare your blog. 🙂 First of all, organizations like GATA – Gold Anti-Trust Action Committee – would argue that gold has been heavily manipulated for over a decade, so the true market price is still much higher. Just using the Fed’s (very low) inflation numbers, gold should be over $2,200 in today’s dollars just to reach the $850 peak of 1980. In addition, gold production has dropped every year since 2005, while the central banks of China, Russia, and India have started making large purchases. John Williams of Shadow Stats would also argue that the average inflation rate since 1980 is closer to 7% than 4% per year.

        Oh, and I’ve read the prospectus for GLD (gold ETF) and the gold can be held by various subcustodians who are not audited. The gold may be there, but if it wasn’t, no one would know.
        Jennifer Barry recently posted..Stranger in His Own Land- Part 3My Profile

        • Jennifer,

          Thanks a million for your expertise. I knew I could count on you.

          I think the gold peak of 1980 is a bad place to calculate from. Looking back into history, today’s prices look pretty high adjusted for inflation. Since the ’70s, the inflation-adjusted average looks closer to $600. Wikipedia has a cool chart showing this.

          I do agree that inflation is way understated by the Fed and I’m positive Shadow Stats is more accurate. Maybe gold is valued more accurately than I thought.

          I didn’t realize central banks were the ones pushing up the gold prices. I figured it was hedge funds and other speculators using derivatives to pump up the prices. I definitely don’t follow precious metals as closely as I should.

  • P.S. Thanks for including me in your recommended reading!
    Kevin@InvestItWisely recently posted..Consumer Ethics and Animals- Where Do You Draw the LineMy Profile

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