Making Sense of Mutual Funds: Getting Down to the Real Nitty Gritty
Mutual funds are the financial version of a smoothie. They contain bits and pieces of different kinds of investments (like stocks, bonds, cash) blended together in different proportions. Just like there are different categories of smoothies with different goals (think protein-based smoothies to build muscle vs. vegetable-based smoothies to lose weight), there are various types of mutual funds. Here are the three primary mutual fund varieties that you should know about.
1. Active Mutual Funds
These are mutual funds where professional portfolio managers spend their days actively watching the various investments in the portfolio and making day-to-day determinations as to whether or not to buy, sell, or hold. In theory, these would be the “best” type of mutual funds as they are being carefully tended. Alas (as my former boss was fond of saying), “Nervous energy is a great destroyer of wealth.” All too often portfolio managers confuse activity with progress (I know – I used to be one!). The end result is that the vast majority of active mutual funds perform worse than the next type, the index fund.
2. Index Funds
Index funds are the little black dress of investments. They are classic, and they make for an ideal staple in your investment closet. Index funds own a basket of stocks or bonds that only change under very rare circumstances (for instance, a company gets acquired, goes out of business, or there is a revamping of the index). Index funds are mutual funds on autopilot. While you might think they’d have subpar performance since no one is in the captain’s seat, history has shown that they actually have generated better returns over most time periods than the vast majority of active mutual funds. Oh, and they cost less too. I’m a huge fan of index funds. (Read our LearnVest article on index funds for more info.)
3. Target Date Retirement Funds
These are the financial version of the chicken rotisserie set-it-and-forget-it machine. Target date funds are mutual funds for which a portfolio manager (or management company) shifts your investments between stocks, bonds, and cash to gradually get more conservative as you get older. There are some target date funds that are composed of active mutual funds and other target date funds (like the ones sold by Vanguard), which are composed of index funds. I am a big fan of target date funds composed of my other favorite: index funds.