What is a stock mutual fund?
A fund that holds stocks of many different companies. A shareholder of the fund owns a fraction of the stock investments comprising the fund. Since a fund usually owns over seventy five stocks, it is somewhat diversified and lessons the risk that bankruptcy of any of the underlying stocks will cause a significant loss to the investor. However, each mutual fund has an investment philosophy as outlined in the prospectus and a growth fund would be more volatile than a value fund.

What is a money market fund?
This type of fund is like a bank savings account except that it is not insured. It owns debt instruments such as treasury bills and bank commercial paper. They are usually valued at one dollar per share all the time, but there is no guarantee of that value. However, the investments are conservative and considered safe by prudent investors. Money market funds pay interest and do not fluctuate with the stock market because they do not own equities.

What is a bond fund?
This type of mutual fund owns long term debt instruments of corporations or governments. The risky bond funds are the ones holding long term debt or junk bonds. Junk bonds are another name for debt issued by risky companies and funds holding these type of bonds are often called “high yield” bond funds. Long term bonds, those that on average mature in over twelve years from now, have risk because their value is determined by what interest rates do today. If current mortgage rates rise by 1%, your typical, long term bond fund would fall in value by 10% or more. If current rates fall by 1%, the bond fund would increase in value. Because long term bond funds experience this volatility, they are riskier than a short term bond fund that has an average maturity of 3 to 5 years.

What does allocation mean?
Once you have determined what your risk level is, you should allocate your money between different types of mutual funds representing distinct asset classes. For example, the money market has very little to do with the stock market. It will not fluctuate with the stock indexes and therefore offers relief from volatility. The more conservative you are, the more you would allocate to a money market fund. Bond funds usually don’t go up or down as much as stocks and they have an interest component: therefore, a high grade, bond fund with an average maturity of 7 to 12 years would not be as risky as a stock mutual fund. Within an asset class such as stock funds, it is also wise to diversify by allocating to stock funds internationally. However, emerging market funds are inherently very risky and should be reserved for the aggressive investor. Comprising the stock class are large cap funds versus small or intermediate cap funds. Large versus small refers to the size of the companies owned by the mutual funds. IBM is a large cap stock and companies with sales under 400M are considered small cap. Small cap is riskier than large cap. Something else to consider within the stock asset class is the philosophy of the manager of the fund which is revealed in the investment policy in the prospectus. A value approach is one in which the fund buys stocks of companies that have low price earnings multiples and are considered cheap. A growth fund prospective is to buy companies that are growing rapidly and have a bright future, but do not have low valuations. A growth stock would be Microsoft and a value stock would be Ford Motor Company. Growth funds usually fluctuate more than value funds, but they also experience higher returns in a bull market. An aggressive investor may put up to 60% of their account in growth type funds to achieve the opportunity of higher returns, while a conservative person should limit growth to 15% of their portfolio.

What is an Index fund?
A fund that owns small portions of every stock comprising an index is called an an index fund. You can chose your index based upon risk, such as the small cap index or the S&P index which contains every type of stock in it. The advantage to index funds is that the internal expenses of these funds are very low, often 1% less than a typical growth fund. A 1% difference in return will mean that you will have 30% more money to retire on in twenty years. The typical S&P index fund has out performed 85% of all mutual funds over the last 10 years. Therefore, indexing your portfolio is a smart thing to do. However, stock index funds will fluctuate with the market and the conservative investor should limit the stock component of the portfolio to 45%.