The Retirement Corporation of America

How Mutual Funds Can Do It All For You

HERE'S THE "60-SECOND" lesson about mutual funds.

•  Nature of the investment: There's a mutual fund for every investment under the sun: stocks, bonds, and cash; U.S. securities and foreign securities. With around 8,000 mutual funds in business, you can reasonably assume that, if someone invests in it, there will be a mutual fund for it.

•  Risk: Nearly risk-free to extremely high.

•  Reward: From modest to extremely high.

•  Role in your retirement savings: Mutual funds can play any role in your retirement savings you want them to play. They are easy to buy and sell. All are professionally managed, so you just pick the fund and someone does everything else. You could own funds alone, or mix-and-match them with stocks and bonds. And although they generally are the first choice for relatively inexperienced investors, many very successful investors never move beyond them.

The World of Stock Mutual Funds

Here are the different types of stock mutual funds—from highest risk to lowest:

•  Aggressive Growth Funds: These go after capital appreciation with a vengeance. They buy highly speculative stocks and their share prices can be extremely volatile. Never buy these funds for current income. They are for all-out growth and capital gains. Few pay dividends.

•  Growth Funds: These try to beat the market by investing in companies with prospects for better-than-average growth, whatever the company's size. However, they often buy the stocks of small or even brand new companies, and their share prices can be volatile. Their primary goal is moderate longterm capital appreciation. They pay only modest dividends.

•  Growth and Income Funds: These funds split the difference between income and growth by investing in stocks that offer both.

•  Equity-Income Funds: These funds split the difference between income and growth, but with the emphasis on income. The typical stock owned by an equity-income fund would have at least some growth potential, but would also pay a fairly substantial dividend on a regular basis.

There are further breakdowns among stock mutual funds. One such breakdown is by the size of the company the fund invests in.

•  Large-Cap Funds: Cap refers to market capitalization, which is the total market value of the company's stock. Stocks in a large-cap fund would have a capitalization of at least $5 billion. These funds stick to "blue-chip" stocks of leading companies. Their twin goals are reasonable capital appreciation and steady income.

•  Mid-Cap Funds: Mid-cap stocks have market caps between $1 and $5 billion. They offer more growth-potential, therefore a higher risk, than large-cap funds.

•  Small-Cap Funds: Since small-cap stocks have market caps of $1 billion or less, these funds stick to fast-growth, low-income types of companies. Most feature fairly high risks, in hopes of fairly high rewards.

Another breakdown among funds would involve their investment philosophy. Here the basic breakdown would be between the following:

•  Growth Funds: As you have already learned, growth funds invest in growth stocks—stocks that have already demonstrated their ability to grow faster than the economy, or that appear to have the potential for very fast growth. Such stocks rarely sell at bargain prices. The fund manager earns his or her fee by picking stocks with sufficient growth potential to justify their high prices.

•  Value Funds: Such funds look for bargains in the market—stocks that, for one reason or another, are selling at what are relatively low prices. The idea is to find stocks that are depressed now, but that have the potential to do much better in the future. The fund manager earns his or her fee by finding those bargains in the market.

Finally, there are the special funds—funds with investment styles all their own.

•  Sector Funds: These can be risky because they only buy stocks in a certain segment of the market, such as financial services, or technology companies. If investing in these companies slows down, or one or two major funds do poorly, all the stocks in that category can suffer. And so can the share prices of these funds.

•  Index Funds: Other funds pick their shots and only buy stocks of a certain size or type of company. Index funds focus on a "universe," the 500 stocks that make up the Standard & Poor's 500-stock index, for instance. Then they buy all, or most, of the stocks in that universe. If the stocks do well, the index fund based on that universe does well. For many investors, an index fund is the place to start. Some investors may only want to own index funds.

The World of Bond Mutual Funds

Here are the different kinds of bond funds, ranging from the least to the most risky:

•  U.S. Treasury/Government Funds: As the name implies, these funds invest in the securities of the United States government, and sometimes in federal agencies that are sponsored by the U.S. government. Other bond funds pay higher rates of interest to investors, but there isn't a better lending risk than Uncle Sam. These funds can be short-, intermediate-, or long-term.

•  Corporate Bond Funds: These funds invest in the bonds of American corporations. They typically buy high-quality bonds of well-known companies who are deemed able to keep paying off their bonds as they come due. Corporate bond funds aren't quite as safe as Treasury bond funds, but they pay a higher yield to offset the slightly higher risk.

•  Municipal Bond Funds: These bonds are issued by states, cities, and other units of local government to finance everything from government operations and the local school system, to building a new airport or a sports stadium. The dividends from all municipal bonds are basically exempt from federal taxes. You can also buy "muni" funds, filled with securities from your state and/or city, whose dividends are also exempt from state and local income taxes. The higher your tax bracket, the more value you gain from having tax-free income.

•  GNMA Funds: They invest in mortgage securities issued by the Government National Mortgage Association—known as GNMA, or Ginnie Mae. What you buy is a share in a pool of mortgages that have been guaranteed by the federal government. GNMA funds typically pay a higher return than Treasury or corporate bond funds, making them suitable for retirement accounts.

•  Income Funds: Strictly speaking, these aren't bond funds, since they split your money among both corporate bonds and high-yield income stocks, such as utilities. What you get is the highest current income of bonds, combined with at least some of the potential for capital gains, plus the inflation fighting factor that you get from stocks.

•  High-Yield Funds: Investment pros call these "junk-bond" funds, and for good reason. They can offer eye-popping yields compared with other bond funds. They invest in lower-quality corporate bonds—you take a higher risk, but can earn a higher return on your money. An investment pro picks bonds for a junk bond fund—making them less risky.

The World of Money Mutual Funds

Every fund family—Fidelity, Vanguard, T. Rowe Price, and all the rest—offer one or more money market funds, as does virtually every 401(k) plan. All money market mutual funds have many things in common:

•  All pay a rate of interest that varies from day to day, according to how well the securities in which the fund has invested are doing.

•  No money market mutual fund offers the potential for capital gains. The price of every fund is fixed at $1 a share.

•  None of the funds are covered by federal deposit insurance—unlike a bank CD, which is covered.

•  Virtually all permit you to withdraw money by writing a check—almost all require that check to be for a fairly substantial sum, such as $250 or $500.

•  All the funds from fund families make it painless to move money back and forth between the money market mutual fund and other funds.

One difference among money market mutual funds is where they invest your money. There are:

•  Regular Money Market Mutual Funds: They invest in the full range of short-term securities issued by the government, banks, and non-financial corporations.

•  Government Money Market Mutual Funds: They invest only in securities of the U.S. Treasury and other agencies of the Federal government. They yield a little less than standard money funds because government issues yield a little less than non-government.

Another difference among money market mutual funds is the tax status of the securities they invest in. There are:

•  Taxable Money Market Mutual Funds: They invest in securities whose income is subject to income tax—federal, state, and local. Therefore, the dividends you earn from such funds are subject to income tax.

•  National Tax-Exempt Money Market Mutual Funds: They invest only in short-term securities of tax-exempt entities, such as cities and states. Dividends earned from such funds are exempt from federal income taxes.

•  Single-State Tax-Exempt Money Market Mutual Funds: They invest only in the tax-exempt short-term securities of entities within a given state. If you are a resident of that state, your dividends are free from federal, state, and local taxes.

Still More Kinds of Mutual Funds

Some funds don't fall neatly into one of the above categories:

•  Balanced Funds: Like income funds, balanced funds invest in both stocks and bonds. But they tend to opt for a higher percentage of stocks than income funds do—meaning they usually yield less than income funds but offer a greater potential for growth. As a rule, balanced funds are stodgy performers, since the stock portion drags down yield, and the bond portion drags down capital growth.

•  Real Estate Funds: They buy real estate stocks, or real estate investment trusts (REITs). Besides capital gains, these funds may also give you some tax-sheltered current income. They pay higher dividends than most stock funds, while offering the growth potential that stocks offer.

•  International Funds: International funds invest only in foreign stock markets. These stock and bond funds give you access you ordinarily wouldn't have to securities markets around the world. They can reward you with great returns. You wouldn't tackle these markets on your own, so international funds are the vehicle of choice.

•  Global Funds: Global funds cover the world investing in both the U.S. and foreign markets, according to which look most attractive at the time.

Why You Want to Own Mutual Funds

In case you're not convinced already, here are Six Clear-Cut Reasons to Consider Mutual Funds:

Reason #1. Diversification: Buy one stock or bond and the risk of loss is high. Diversify your money over many stocks or bonds, and the risk of all going bad is much lower. The more you diversify, the less risk your money is exposed to. Mutual funds invest in many stocks or bonds, making them the easiest way to get the diversification you need.

Reason #2. Professional management: Mutual funds are managed by investment professionals. A professional fund manager is likely to do better than you could on your own.

Reason #3. Low cost: Most mutual funds let you start with $3,000 or less, many for $1,000 or less. And you can make smaller purchases after that. Even a small retirement savings account will let you diversify over three or four different funds.

Reason #4. Easy access to other markets: Would you know which corporate bond to buy, or how to buy a biotechnology stock? Mutual funds open the door to investments and markets you couldn't or wouldn't tackle on your own.

Reason #5. Lots of available information: There's more readily-available information about mutual funds than you could read in a lifetime. The Internet alone features hundreds of such sites.

Reason #6. They're easy to buy and sell: Buy "load" funds through a stock-broker or financial planner by paying a commission, or load, to do so. Buy "no-load" funds directly from the fund company without paying a commission. You'll find ads for no-load funds everywhere. And the mutual fund company you buy the shares from has an obligation to buy them back from you.

What to Beware of with Mutual Funds

Why should anyone look beyond funds? Because, for all the advantages of mutual funds, they also have some severe disadvantages for the typical investor.

•  High sales commissions: There are plenty of no-load funds to choose from that don't charge a sales commission. But if you want some hand-holding in picking a fund, expect to pay the broker or financial planner a commission of around 5 percent.

•  High expenses: Figure more than 1 percent in annual expenses for each fund you own, although index funds, as a rule, charge much lower expenses (usually under 1/2 of 1 percent).

•  Style drift: You may think you are buying a conservative mutual fund, but the manager has wide discretion over what he invests in. That conservative fund may actually be loaded with on-the-edge Internet stocks, because the manager needs them to boost fund performance.

•  Soggy performance: Some mutual funds have done well through the market's ups and downs. Index funds, by definition, have at least matched the market they were created to match. But the average mutual fund, actively managed by a fund manager, has seldom even matched the performance of the market.

•  Tax "time bombs": Whenever the fund sells shares, the tax consequences are passed directly to you. If the fund sold 100,000 shares of Cisco Systems at a huge profit, your share of the profit is distributed and you immediately owe taxes on that profit. Instead of the nice tax refund you were hoping for, you instead must pay a fortune because of the capital gains on the sale of Cisco Systems stock. The fund may have had a terrible year, actually losing money for you. No matter, if it earned capital gains by selling off some of its winners, you get stuck with a tax bill.

How to Create an OK Mutual Fund Strategy

Be aware of both the strengths and weaknesses of mutual funds. Then build your investment strategy, using these Five Safe and Sane Rules for Successful Mutual Fund Investing.

1. Spread your bets: Choose several different kinds of funds--not just stock or bond funds, but some of each. Stocks and bonds don't always rise and fall together. What you lose when the bond market has a bad year, you can often make up in stock gains, and vice versa. That's asset allocation in action.
2. Diversify within asset categories: For your stock funds, don't just pick aggressive stocks that take risks in the pursuit of big capital gains. When they gain, they gain big. When they lose, they lose big. Since they seldom pay dividends, diversify by adding some conservative stock funds that take fewer risks but do pay dividends. When they do lose, you have the dividends to help make up for the loss.
3. Pick funds that are well diversified: Buy only funds that invest in at least 100 different stocks, or 100 different bonds. You are buying a mutual fund because it offers built-in diversification, so you get the diversification you're paying for.
4. Stick with your strategy: Decide on a long-term strategy and stay with it. Don't let yourself be drawn in by the latest hot investing fad, or don't sell at the first sign of weakness in the market. Stick to your guns and stick to your strategy. Consistency is the hallmark of successful investing.
5. Keep time on your side: Your goal of a secure retirement is a long-term goal. You reach long-term goals with a long-term investment strategy. Don't chase after today's hot stock or hot mutual fund. Don't sell at the first sign of trouble in the market. For more than 70 years, the average stock fund has returned 10 percent a year, and the overall diversified investment portfolio has returned 7 percent a year. Keep time on your side, and you'll do fine.