Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the whims of the market and thus offer a higher return potential than bonds, but they also present more risk. Bonds, by contrast, provide a fixed return that is usually much lower than what an investor gets from stocks. The advantage of bonds is they are low risk. Only in an extreme situation, such as the complete failure of a corporation, does an investor not receive the return he was promised from a bond security. A mutual fund's investment profile depends on the type of fund. There are three main types: equity funds, fixed-income funds and balanced funds.
Equity funds are mutual funds that invest only in common stock. They offer the biggest returns but also the highest risk. An equity fund, however, still presents a lower risk than investing in individual stocks. The reason is an equity fund is a bundle of hundreds or even thousands of stocks. It is diversified by its nature. If one company in the bundle tanks, the investor's exposure is very limited since his money is spread across hundreds of companies.
Fixed-income funds invest only in government or corporate bonds that offer fixed returns. These mutual funds are much less risky since they provide the same return whether in a bull market or a bear market. However, investors who choose fixed-income funds because of lower risk must also accept, in most cases, lower returns.
Balanced funds feature a mix of equity and fixed-income investments. Their return potentials and risk levels fall between that of equity funds and fixed-income funds. Balanced funds occupy a broad gamut. Some are stock-heavy, while others are comprised of mostly bonds and feature only a smattering of equities. Plenty of balanced funds exist from which to choose; diligent investors can almost always find one whose makeup corresponds with their risk tolerance and desired return potential.
Kristi Sullivan, CFP®
Sullivan Financial Planning, LLC, Denver, CO
Mutual funds specialize in a variety of areas. Some are invested only in stocks or bonds, while others invest in real estate investment trusts, commodities contracts, etc.
Often, you can tell what the fund invests in by its name. For example, the Vanguard 500 Index fund is invested in the S&P 500 Index, which includes the 500 largest U.S. stocks. The PIMCO International Bond fund is invested in non-U.S. bonds.
The fund's specialty is not always in the name of the fund, so extra research is needed to find out what a mutual fund is about.
There are also funds that invest in a little of everything. These are called asset allocation or target-date funds. The idea is to make it easier for the investor to have a professionally managed mix of mutual funds without all the work.