Mutual funds can generally be placed into one of three primary categories: stock, bond or money market. Many investors will diversify their portfolio by including a mix of the three.
Stock funds, also called equity funds, are the most volatile of the three, with their value sometimes rising and falling sharply over a short period. But historically stocks have performed better over the long term than other types of investments. That’s because stocks are traded on the expectation that a company’s future results will include expanded market share, greater revenues and higher profits. All of that would increase shareholder value.
Generally stocks fluctuate because of investors’ assessment of economic conditions and their likely impact on corporate earnings. Socially responsible investors also factor in other risks to earnings such as exposure to fines or lawsuits from polluting the economy or discriminating against particular employees.
Not all stock funds are the same. Some common funds include:
- Growth funds, which offer the potential for large capital appreciation but may not pay a regular dividend.
- Income funds that invest in stocks that pay regular dividends.
- Index funds, which try to mirror the performance of a particular market index, such as the S&P 500 Composite Stock Price Index..
- Sector funds usually specialize in a particular industry segment, such as finance, health care or technology
Bond funds, also known as fixed income, invest in corporate and government debt with the purpose of providing income through dividend payments. Bond funds are often included in a portfolio to boost an investor’s total return, by providing steady income when stock funds lose value.
Just as stock funds can be organized by sector, so too bond funds can be categorized. They can range in risk from low, such as a U.S.-backed Treasury bond, to very risky in the form of high-yield or junk bonds, which have a lower credit rating than investment-grade corporate bonds.
Though usually safer than stock funds, bond funds face their own risks including:
- The possibility that the issuer of the bonds, such as companies or municipalities, may fail to pay back their debts.
- The chance that interest rates will rise, which causes the value of the bonds to decline
- The possibility that a bond will be paid off early. When that happens within bond funds there is the chance the manager may not be able to reinvest the proceeds in something else that pays as high a return.
Money Market Funds
Money market funds have relatively low risks, compared to other mutual funds and most other investments. By law, they are limited to investing only in specific high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments.
Money market funds try to keep their “net asset value” (NAV) — which represents the value of one share in a fund — at a constant $1 per share. But the NAV may fall below $1 if the fund's investments perform poorly.
Historically the returns for money market funds have been lower than for either bond or stock funds, leaving them vulnerable to rising inflation. In other words, if a money market fund paid a guaranteed rate of 3 percent, but over the investment period inflation rose by 4 percent, the value of the investor’s money would have been eroded by that 1 percent.