Contents
Mutual Fund Basics
Why Invest in Mutual Funds?
Mutual Fund Returns
Types of Mutual Funds
Mutual Fund Investment Holdings
Funds vs. ETFs, Stocks, and Bonds
How to Plan a Mutual Fund Portfolio
How to Research Mutual Funds
How to Buy Mutual Funds
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How to Plan a Mutual Fund Portfolio
A mutual fund portfolio is an assortment of funds designed to maximize returns while minimizing risk. The following process will help you begin planning your own fund portfolio.
- Assess your risk tolerance.
- Determine your asset allocation.
- Allocate your funds based on your various types of accounts.
Risk Tolerance
Risk tolerance refers to your ability to tolerate, or manage, declines in the value of your investments. Risk tolerance is not a quantifiable figure. Instead, it’s a subjective assessment that depends on both practical and personal factors:
- Available funds: Only invest money that you don’t need to cover your everyday bills and expenses (or anticipated expenses, such as upcoming medical bills). The less you “need” the money you’re investing, the higher your risk tolerance.
- Time horizon: Risk tends to decrease the longer you hold on to your investments. The shorter your time horizon—the amount of time you expect to hold your investments—the lower your risk tolerance.
- Risk aversion: Your personal tendency to avoid or relish risk-taking. The more you can stomach risk, the higher your risk tolerance will be in terms of investing.
Over time, risk and reward typically go hand-in-hand: the greater the risks you can tolerate, the greater your possible rewards. Based on your available funds, time horizon, and risk aversion, you can decide how aggressive or conservative your ideal mutual fund portfolio should be:
- Aggressive: Accepting bigger risks for the long-term potential of bigger rewards
- Moderate: Limiting risk somewhat while also limiting potential reward somewhat
- Conservative: Limiting risk while also limiting potential reward
Asset Allocation
Asset allocation is the process of buying various types of stocks, bonds, and other securities in order to create a diversified investment portfolio. The relative risk and reward of a mutual fund generally depends on security type it holds. Based on the different risks associated with different types of funds, you can allocate your assets across different funds to make sure that your investment is exposed to the right amount of risk (and potential reward) for your particular situation.
Sample Asset Allocations
The following pie charts show sample asset allocation strategies for moderate, conservative, and aggressive mutual fund investors. These rough guidelines can help you allocate your investable funds to position your investments for the greatest potential growth while limiting risk to a level that suits your financial situation and personality.
Conservative Asset Allocation
Moderate Asset Allocation
Aggressive Asset Allocation
Types of Mutual Fund Accounts
When planning a mutual fund portfolio, you also have to consider the type(s) of account in which your mutual fund investments will be held. There are three main types of accounts; you can hold mutual funds in just one type, or all three. The type of account in which you choose to hold each fund should depend on the tax advantages of the account and the tax-related traits of the fund, as explained below.
Tax-Deferred Accounts
Tax-deferred accounts allow you to delay paying taxes on investments you make for specific purposes, such as retirement. The most popular type of tax-deferred account is the traditional IRA. If you own mutual funds in a tax-deferred account, you won’t pay taxes on interest or dividends that the fund pays, or on capital gains taxes that the fund incurs, until you begin withdrawing from your account, usually after age 59 1/2. The best types of mutual funds to hold in tax-deferred accounts are those that make average dividend or interest payments that don’t qualify for the reduced 15% tax rate (such as bond funds and REIT funds), or those that have high turnover rates (over 50% or so).
Tax-Free Accounts
Tax-free accounts let you make after-tax contributions into investment accounts that can then grow tax-free. The three most popular types of tax-free accounts are Roth IRA, 401(k), and 529 accounts. The best types of mutual funds to hold in tax-free accounts are those that make significant dividend or interest payments that don’t qualify for the reduced 15% tax rate, or those that have an unusually high turnover rates (100% or more).
Taxable Accounts
Most general investment accounts are taxable accounts, which offer no special tax advantages. The best types of mutual funds to hold in taxable accounts are those that make little or no dividend and interest payments, or those that generate large capital gains tax liabilities.
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