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Are you guilty of fund collecting? The main categories of mutual funds Diversification helps manage risk Finding the right investment mix for you

When you sit down to evaluate your portfolio, do you have trouble remembering exactly why you bought certain funds in the first place?

Do you buy funds randomly, based on a magazine or newspaper article?

If you answered yes to either of these questions, you may be guilty of fund collecting.

Mutual Funds: Diversification With A Single Manager, A Single Style

Mutual funds are pools of securities, which typically offer diversification within one or more asset classes. In general, people invest in mutual funds in order to achieve diversification in their portfolio without the trouble of managing a large number of stocks and bonds.

With more than 8,750 mutual funds available today, some people have started collecting mutual funds. The downside: potentially lower returns on your portfolio.

Mutual Fund Investments: The Main Categories

Balanced.

Use a mix of stocks, bonds, and money markets to try to generate moderate growth and income while carrying moderate risk.

Bond.

Invest in government, Treasury, and municipal bonds to provide revenue and help reduce market risk.

Global.

Invest in foreign securities seeking to balance out single market performance risk. May include a percentage of domestic holdings.

Growth.

Actively buy and sell stocks in an attempt to generate high potential returns. May use high-yield bonds or mortgage derivatives, which are subject to a greater risk of loss, including default risk, which results in greater share price volatility. Carry higher market risk than other fund types.

Index.

Strive to post returns comparable to those of a benchmark index for investment category. Risk varies with asset class. Keep in mind that investors cannot directly invest in an index.

Money market.

*Invest in high-quality bonds, commercial paper, and bank notes. Seek to maintain a stable share price and generate income. Carry a relatively low market risk, but their lower returns are susceptible to inflation risk.

*An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

Small-cap.

Buy and sell stocks of smaller companies in search of high return potential. Many of these funds are aggressive growth funds and carry higher risk.

Large-cap.

These growth funds buy and sell stocks of larger, well-established companies in search of high return potential and a relatively lower degree of volatility.

Value.

Seek to maintain principal and generate modest income by investing in out-of-favor or undervalued securities. Low annual return potential may not outpace inflation.

Holding Multiple Funds: Different Goals And Management Styles

The number of funds that is right for you depends on your investment goals, risk tolerance, and the amount of your investment capital. If you have both short- and long-term goals, you will likely want different types of mutual funds for each time frame. The more capital you have to invest, the greater your ability to afford diversification among different asset classes and investment styles.

Asset allocation refers to how you weigh the investments in your portfolio. There are three main asset classes: stocks, bonds, and money markets. Each has its own characteristics in terms of value fluctuation, level of market risk, and ability to outpace inflation. Which asset classes you decide to invest in depends on how your investment time frame and goals match up with the risks and return potential of the various asset classes.

Diversification Helps Manage Risk

The concept of diversification — the process of investing in different types of funds or securities in order to reduce risk — is an important part of asset allocation. Diversifying among different asset classes increases the chance that as one investment is falling in value, another may be rising. A mix of assets may help position your portfolio to benefit during market upswings, while suffering less during downturns.

If you have sufficient capital, you can also diversify among investment styles to further help reduce risk.

Are You An Active Or Passive Investor?

Active and passive investing are the two most basic investment styles. While active investing relies on the ability of managed funds to outperform the market, passive investing relies on the long-term success of market indexes.

Active investing is further divided into the two categories of growth and value. Growth funds typically invest in well-established companies with high earnings potential. On the other hand, value funds invest in companies that have recently fallen out of favor but are expected to bounce back. Many investors prefer to combine investment styles in order to potentially gain through the different market cycles that favor different approaches.

Finding The Right Fund Mix For You

How many funds you need and how much you invest in each fund will depend on your investment goals, risk tolerance, and time horizon.

Generally speaking, if you have more to invest, you might want to consider adding a wider variety of stock and bond funds to your portfolio. However, with so many funds in the market, it is inevitable that there are several funds with similar strategies and performance. These funds invest in similar stocks and follow analogous investment styles.

If you hold several funds that all use similar investment strategies in your portfolio, you essentially hold the market. You could achieve the same result much more cost-effectively by simply buying an index fund.

Review Your Portfolio With Your Financial Professional Regularly

Each fund that you invest in should play a specific, defined role in your portfolio. A financial professional can help you evaluate each fund and its role in your portfolio.

Points To Remember

1. People invest in mutual funds in order to achieve diversification without the time and cost of keeping track of hundreds of individual securities.
2. Before picking a mutual fund, consider your investment goals, risk tolerance, time frame, and amount of investment capital.
3. Diversify among different asset classes to help manage risk and potentially increase the rate of return of your portfolio.
4. Diversify among different investment styles to help manage risk and potentially increase return potential.
5. Owning too many funds means you may be diluting the potential benefits of active management by covering too much of the market — in a word, over-diversifying.
6. Your financial professional can help you evaluate each fund to determine its role in your portfolio.

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