As with all investment vehicles, there will always be options for you to choose from. The investment you make has to be something that suits both your investment style and personality. The same can be said when picking a mutual fund. It is important to understand that there are a lot of mutual funds out there and they can be broadly categorized into a few groups. Each group has inherently different risk and potential return level. Of course, as a general rule of thumb, the higher the risk, the higher the potential of reward level.
As a new mutual fund investor, here are the three different types of mutual funds that you should know of and be familiar with:
1. Stock Funds – Stock funds are by far the most popular and most commonly invested type of funds in the market. As the name suggests, a stock fund consists of mainly stocks that are poised for substantial long term growth. The nature of stocks that are being picked for the mutual fund are also classified into a few different categories, growth stocks, value stocks, large cap, small cap, which we will cover in later chapters. For now, you need to understand that stock funds fluctuate with the market. If the market is bearish, the performance of stock funds will dip in form as well. This is why we say when you are heavily invested in stock funds, you might be exposed to market risks.
2. Fixed-income Funds – Fixed-income funds or bonds are another class of mutual funds that are made up of mostly government and corporate bonds. This means that you are buying the government’s or corporates’ debt. Bonds work a little differently from stocks because their price is not entirely in sync with the fluctuations of the market. This also means that one does not simply buy bond funds for hopes of selling it at a later date for profit. Bonds are instead designed to provide a consistent flow of cash to the investor in the form of interest repayment. It is important to note that as the interest rate of the bond goes up, the value of the bond falls and this exposes investors to interest rate risks. However, investing in fixed-income funds is a lot more conservative and certain than stock funds.
3. Money Market Funds – Money market is made up of high-quality, short-term investments issued by the U.S. Government, U.S. corporations, and state and local governments. Funds that are made up of money markets are usually very low risk in nature and you don’t have to worry about losing your principal sum. However, the downside is that you will not get a high potential return. If you put this into perspective, a typical investment in a money market fund will yield you twice the rate you will achieve by parking your money in your local bank’s savings account. That’s not too bad, isn’t it?
Of course, this list is not exhaustive. There are specialty funds and international funds which are out of scope in this mini-course for new investors. For now, understand these 3 funds thoroughly and we are all set to move on.