Let’s continue our discussion of mutual funds by examining their risk / reward characteristics we discussed in a prior post. This will help you determine the types of investments that are best for which savings goals. See our introduction to mutual funds here.
Money market funds – Since the risk of losing money is extremely low, I hope you can predict by now that the reward will also be very low in the form of dividends. Liquidity risk is very low since you can easily redeem your shares, almost certainly for the same price you paid for them. The risk of not keeping up with inflation is very high since the low dividend yield usually is less than the inflation rate. Therefore, money market funds are best for keeping savings that you may need soon or really want to keep safe, but it will not grow fast enough to meet long term goals such as college and retirement savings.
Bond funds – Bond funds are riskier than money market funds since you can lose money, but that means they yield more. Bond funds have many of the same risks as individual bonds – you can lose money from interest rate changes, early redemptions, and defaults – but the risk is spread out among many different bonds and investors which is a key advantage of mutual funds. Bond funds are more liquid (much easier to buy and sell) than individual bonds. Whether they can keep up with inflation depends upon the type of bond and its yield. Bonds aren’t as volatile (big price swings) as stocks. Therefore, bond funds are good for savings you may need in the middle term (3-5 years) and to balance your stock investments so your overall investments aren’t as volatile.
Stock/equity funds – As you probably guessed, stock funds have basically the same risks and rewards as individual stocks – high volatility, risk of losing money, easy to buy and sell, good investment to beat inflation, and historically among the best returns, on average over time. They are the riskiest of the three types of mutual funds we have discussed, which means they also have the best potential for rewards which can come from both dividends and price appreciation. Stock funds provide easy diversification over individual stocks. Since the have the greatest potential for growth (on average, over time), they are best for your long-term savings such as retirement and college savings.
Combo funds – Since different investments have different risks, it’s natural to want to mix and match them. In fact, there are several types of mutual funds that strive to balance these risks including target date, life cycle, and balanced funds. They combine stocks, bonds, and sometimes money market funds and strive for a combination of safety, income, and modest capital gains.
Since there is a huge variety of mutual funds, there is a huge variety of risk among them. This is especially true based upon how diversified a fund is among a variety of different types of investments. A fund that invests in just one type of stock or bond such as one industry sector, world region, country, or market capitalization will be less diversified and more risky than a broad based fund that invests in many companies across multiple industries, countries, and market caps. Some mutual fund screens may include risk/volatility ratings so you can compare them with other funds in their category and among fund types.
While we are talking about risk, let me repeat that no mutual fund, not even money market funds, are federally insured against losses.