Mutual funds are great investment vehicles that come with many misconceptions. Because most are managed by professionals and come with a basket of various investment products, there’s often a “set it and forget it” mindset associated with them. In other words, investors buy into a mutual fund and then forget about it, never bothering to follow up on performance or strategy.
With over 14,000 mutual funds available, selecting the right one or ones to fit your needs can seem like a daunting task. However, all funds obey certain rules that actually make selecting the right one a little easier. All you need to know is your personal risk tolerance beforehand.
Mutual Fund Management
Because mutual funds are touted as diverse investment vehicles, many investors take that at face value and think owning a mutual fund means automatic investment diversification; it’s a mistake that can end up costing you a lot of money down the road.
When you’re looking at a potential mutual fund, you’ll want to figure out what type of fund it is and what its investment strategy is. A common fund type is known as a balanced fund. While the allocations vary from fund to fund, the most common allocation is 60% invested in equities and 40% invested in bonds and other conservative products. This mix gives investors a fairly diverse portfolio already but shouldn’t be the entirety of one’s investment plan.
Mutual funds are required to stay within a certain allocation range. Taking from our example above, the hypothetical balanced fund might be able to increase or decrease its allocation by, say, 10% either way. If the fund manager is bullish on the economy, he or she might change the mix to include 70% equities and only 30% bonds. If they’re more cautious, they might split it 50-50.
While it does help investors weather the dynamic global economy, such an allocation won’t necessarily fit into your specific risk tolerance. It also leaves out other important diversification considerations, such as international investments or sector-specific strategies.
One simple rule of thumb for risk tolerance is to subtract your age from 110 to determine what percentage of your portfolio should be in equities. If you’re 30 years old, for example, you would want at least 80% in stocks and no more than 20% in bonds.
In order to achieve the right mix, you’ll need to spread your mutual fund investments into at least two separate funds – probably more if you’re including international exposure. Just remember to balance out your investments in order to get the percentages correct for what you need.
The Bottom Line
Mutual funds are ideal investment vehicles that can help you plan for retirement or reach your savings goals, but they aren’t infallible. Diversification is critical, but keeping your allocations on track is just as important. Over time, equities outpace bond investments, so you’ll want to monitor your allocation changes every so often. Any change under 10% isn’t significant, but once you start diverging by more than that, you’ll probably want to sell some stocks and put those gains back into bonds so you don’t get too far off track.