We’ve discussed some of the most common types of investments (stocks, bonds, CD’s and savings accounts). Each investment type has its advantages and disadvantages, and ideally you should have funds in each type. Retirement savings should be in stocks and bonds, and your everyday savings and emergency fund should be in savings accounts and maybe some CD’s.
But just knowing what these various investment instruments are isn’t enough. For the average Joe/Jane investor, what is the best way of actually building an investment portfolio? There are basically two ways of doing this: you can pick out and buy individual stocks and bonds or you can invest in what are called “mutual funds.”
Mutual Fund Basics
A mutual fund is an investment that allows you to invest in a multitude of stocks or bonds all at once. These funds are typically operated by large investment firms, such as Vanguard, Fidelity, T. Rowe Price, and others. Individual investors such as you and me can then buy into the fund, hence the name “mutual fund.”
Mutual funds come in a number if varieties. There are bond funds for government bonds, municipal bonds, corporate bonds, and combinations of each type. There are stock funds for large companies, midsize companies, small companies, specific industries, international companies, etc.
Mutual Fund Advantages
An important feature of mutual funds is that these funds are managed by investment professionals at the sponsoring investment firm. You see, the problem with individuals like you and me buying individual stocks is that, in order to have a diverse portfolio (lots of different companies, of different sizes, and in different industries) you have to have a lot of money to invest. Not only that, but you have to spend a lot of time researching the companies financial data before investing in them. Personally, I have no doubt that I could do the research and build a nice, well-diversified portfolio of stocks and bonds. But it would take me a lot of time to do that research. This is despite the fact that I have a strong financial background with a bachelor’s degree in accounting, an MBA with a concentration in finance, and having worked in corporate accounting and banking for my entire working career. The point is that the averge investor simply doesn’t have the time and resources necessary to successfully pick individual stocks on a consistent basis. I know there are exceptions to every rule, and most of us know someone that has done very well buying individual stocks. But again, that us the exception rather than the rule.
How Do I Get Started?
If your primary source of investing is through your employer-based 401k plan, your investment choices most likely already consist of mutual funds.
However, if your employer doesn’t offer a 401k or you are self-employed, you can open an IRA at any of the investment firms I mentioned earlier and invest in mutual funds. You can also invest in mutual funds through any brokerage firm (online or through an actual broker).
As far as choosing individual funds, I highly recommend stock index funds for the bulk of your investing. An index fund is representative of the overall stock market as a whole, so it is pretty well-diversified. Additionally index funds typically have very low fees, so you get to keep more of your investment returns.
A good idea is to invest in several different types of mutual funds to stay diversified and minimize risk. For example, you could invest in a stock index fund, a bond fund, and an international stock fund. This would give you exposure to U.S. stocks, foreign stocks, and more conservative bonds.
An even easier option is to invest in what is called a “target date retirement fund” that automatically adjusts its investment holdings to become more conservative as you approach retirement. So basically you would only need to invest in one fund. Not all 401k plans offer target date funds, though.