If you're looking to diversify your investments, mutual funds are a great place to start. Balanced funds, in particular, are an excellent addition to your portfolio because they are easy to tailor to your investing goals and risk tolerance. In addition to their customizability, other benefits of balanced funds include professional management and increased diversification relative to other types of funds.

What Is a Balanced Fund?

There are numerous types of mutual funds, but they primarily fall into one of four categories: stock funds, bond funds, money market funds and balanced funds.

While stock and bond funds invest only in the securities that give them their names, money market funds invest in highly liquid short-term debt instruments issued by only the most credible entities – primarily governments, municipalities and the highest-rated U.S. corporations.

Stock funds provide the possibility of high returns, but they also carry high levels of risk. Bond funds are generally more secure, but they are less likely to generate substantial gains. Money market funds are the most stable of all, but they offer very low returns relative to other types of funds. All three types of funds may have negative effects on your income tax burden due to annual dividend and interest payments.

Only balanced funds take the benefits of each type of investment and combine them into a single fund. Balanced funds include a mixture of different investment types that, when combined, create a portfolio that meets shareholders' needs.

Customizability: Your Risk Tolerance Level

Volatility and risk are inherently tied to the potential for the success and failure of a given investment. You can't make big gains without taking on some risk of loss. If you can handle more risk, you gain a greater possibility of profit. You are almost guaranteed to find at least one balanced fund that fits your specific investment style and financial goals. Because these investments combine the advantages of stocks, bonds and short-term debt securities, fund managers can tailor each fund to the specific risk tolerance of its shareholders.

For example, assume you are happy to risk a small portion of your investment to reap potentially huge profits, but you still want to keep most of your capital investment safe. A balanced fund that is primarily comprised of government or highly rated corporate bonds but also includes a few volatile stocks provides security with just a dash of risk. If the stocks do well, the fund will see some profit, though not as much as if you invested in an aggressive portfolio comprised solely of stocks. However, if the stocks flounder, the fund's value will remain relatively stable, since most of its capital is safely tied up in low-risk bonds.

In general, investors with higher levels of risk tolerance should pick balanced funds that are more stock-heavy, while investors who prefer to keep their investments safe in exchange for more modest returns should go for balanced funds with an emphasis on highly rated bonds and other debt securities.

Customizability: Tax Efficiency

Balanced funds can also be customized to meet investors' tax needs. All types of investments have tax implications, but you can choose a balanced fund that combines your investment goals with your tax needs.

Mutual funds are called pass-through investments because they are required to pass on all their net profits to shareholders each year to avoid paying income taxes on those earnings. The fund's shareholders end up paying taxes on the fund's gains. Mutual funds make two types of distributions: capital gains distributions are made when the fund makes a profit off the sale of an asset in its portfolio, while dividend distributions occur when the fund's assets pay dividends or interest.

Depending on how long the fund has held the asset in question, these distributions may be taxed at your ordinary income tax rate or at the much lower capital gains rate. The difference between these tax rates can be as much as 20%, so it is very important to understand how your fund makes money and how its distributions affect your yearly taxes.

If you want to minimize your yearly investment income in the near future in exchange for larger payouts down the road, look for balanced funds that employ a buy-and-hold investment strategy but don't include dividend-bearing stocks or interest-bearing bonds. These funds are often referred to as tax-efficient because they make few yearly distributions, if any, instead making a small number of much larger long-term gains distributions over time that are taxed at your capital gains rate.

Increased Diversification

The automatic diversification that comes with mutual fund investment is one of the primary attractions for most investors. Instead of working tirelessly to create a portfolio that adequately mitigates risk by spreading it across a wide variety of investments, you can simply invest in shares of a mutual fund and allow the fund's manager to do all the legwork for you.

Balanced funds are the most diverse type of mutual fund. Rather than focusing on just stocks, bonds or short-term debt instruments, balanced funds can combine all of these investment types to create a portfolio that provides the best of all three.

For example, it is nearly impossible for stock funds to provide full protection for your initial capital investment. No matter what stock it includes, at some point, the fund will have to sell one of its assets at a loss when the stock price dives below what the fund paid for it. While bond funds can offer a much higher degree of security by investing in bonds or short-term debt instruments issued by the U.S. government – which is far less likely to declare bankruptcy than any corporation – they cannot provide the same opportunity for profit as stocks. Balanced funds provide both advantages because they invest in a wider range of securities in various combinations.

Professional Management

Mutual funds are managed by professional investors whose only goal is to see the fund turn a profit. Because balanced funds require a high degree of fine-tuning to achieve the optimal balance of investment types, this professional guidance is of utmost importance.

If your portfolio only contains a handful of investments, you may be able to scrutinize their past performance and future potential sufficiently. However, mutual funds provide a level of diversification that individual investors generally cannot replicate on their own. Keeping track of that many investments and knowing the daily movements of the market would require constant vigilance to manage your portfolio properly. Fund managers literally do nothing else but monitor the fund's portfolio and all of the factors that can influence its performance to ensure the best possible outcome.

The investment style of the fund's manager is very important. If you want an investment that generates long-term gains and has a lower expense ratio, choose a fund with a manager who employs a buy-and-hold strategy that allows the fund to grow over time with little buying and selling each year. This doesn't mean the manager is not actively involved in the fund, but rather that he limits fund volatility to provide stability rather than constantly chasing the next big swing.

If you want a fund that aggressively invests in cutting-edge stocks and works to increase bond yields by trading often, a highly active manager can provide the roller coaster ride of fund volatility that can bring in huge profits and massive losses. However, the increased trading activity is likely to result in a higher expense ratio.

Conclusion

Whether you are an experienced investor or just a beginner, balanced funds are an excellent addition to your investment portfolio. Speak to your financial advisor about which funds are best suited to your specific goals, risk tolerance and tax needs to ensure that you invest in a fund that adequately meets your needs.

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