Stock mutual funds tend to be the riskiest type of investment, but also tend to yield the highest earning potential.
Not all stock market investments are created equally. Some funds perform better than others – how will you decide which type of stock fund makes sense for you? Let’s look at the different types.
* Index funds. They tend to mirror the market. They are made up of collections of stocks that basically “match” the market; if the market goes up, the fund goes up accordingly; if the market goes down, the fund goes down at a similar rate. Different funds are intended to “match” different indexes. An S & P 500 index is made up of a combination of all the stocks represented on the S & P 500. Because they automatically provide diversification, index funds have been the safest way to get a steady return on your investment. That assumes, of course, that the future will be similar to the past – and there is no guarantee that will be the case.
If your retirement plan does not include an index fund, the odds are good that it does include a something similar to an index fund.
* Growth funds. They buy stocks assumed to have the potential to grow substantially in value. Within the growth fund category, you may find sub-categories like:
o Aggressive growth funds, which tend to focus on riskier but potentially higher-return stocks
o Moderate growth funds, a blend of moderately risky stocks
o Value funds concentrate on purchasing relatively stable stocks, often stocks that pay a small dividend which add to the growth of the fund’s value
Many plans offer a lot of other sub-categories. Your plan should describe the goals and level of risk in each sub-category, so you can evaluate those investments based on your willingness to accept risk and your desire for return.
* Small-, medium- and large-cap funds. They are often described by the size of the companies they invest in. One way to define “size” is by market capitalization. Market “cap” does not refer to the size of a company (for example, its number of employees, number of locations, etc), but refers to the stock market value of the company. To calculate market cap, multiply the number of shares outstanding in the company by the price of those shares. The result is the market capitalization value. (For example, if a company has a million shares outstanding, and those shares currently sell for $10, the market cap is $10 million.) Now let’s break each segment down:
o Small-cap funds typically invest in companies that have a market value of less than $1 billion. Small-cap funds do sometimes yield high returns but should also be considered fairly risky investments.
o Mid-cap funds invest in companies that have values ranging from $1 billion to $8 billion or so. Mid-cap funds tend to be less risky than small-cap funds, but also tend to produce a lower rate of return over the long term.
o Large-cap funds invest in companies with market values over $8 billion. Large caps sometimes appear similar to an index fund, because a large cap fund may invest in all the companies in a particular index, like the Dow Jones Industrials. Large-cap funds tend to be less risky, but at the same time tend to provide a lower return on investment.
* Sector funds. They invest in companies in a particular industry, like technology, or pharmaceuticals, or oil companies, or health care, etc. If you think a particular industry is on the verge of rapid growth, investing in a sector fund could be a great way to enjoy a great return while diversifying your investment across a number of different companies in that sector.
* International funds. These invest in stocks from countries all around the world. (By the way – I feel investing internationally is an extremely good idea. A number of countries are experiencing phenomenal growth.)
* Income funds. They invest in stocks that pay a regular dividend. Income funds also invest in bonds that pay interest. Many income funds invest in both. The goal of an income fund is to minimize risk while providing a stable, albeit small, return on investment.
* “Life cycle” funds. These attempt to provide a blend of stocks and other investments designed to match your age and investment goals. The goal is to create a blend of fund types to match your level of risk and desire for return. Different investment funds call their “life cycle” funds by different names. Some examples include:
o Conservative, Balanced, Growth, and Aggressive allocation funds. Each of these tries to be what it is called. A Conservative fund invests conservatively and minimizes risk.
o Destination 2020, Destination 2030, Destination 2040 allocation funds. Each Destination fund makes investments based on when an individual plans to retire. A Destination 2040 is intended for someone planning to retire in 2040.
Again, different investment companies call their “life cycle” funds by different names. Each will describe the goals of the fund. Take the time to determine whether a particular investment meets your needs.
After all, that’s the magic of a 401(k) plan. You don’t have to choose just one type of investment. You can spread your money across different funds to match the level of risk you are willing to take on with the rate of return you hope to achieve.
If you’re new to investing, your best bet is to start by taking a relatively conservative approach. Over time, you should learn as much as you can about stock investing, bond investing, and other types of investing. With more experience you will develop a solid feel for how you wish to invest your money, and also for how much risk you are really willing to face.
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