Understanding Mutual Funds

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Mutual funds pool money from investors to purchase shares in a particular asset class. Funds may invest exclusively in one asset class, such as exclusively stocks or bonds. Or they may invest in more than one asset class, such as asset allocation and targeted-maturity funds, which may include a mix of stocks, bonds and/or cash equivalents. Here are some examples of mutual funds types:

Balanced Funds: These funds, sometimes called asset allocation funds, invest in both stocks and bonds (and sometimes other types of assets). The goal of these funds is to reduce the effects of market volatility (fluctuations in value) by investing in different asset classes that have low correlation with one another.

Lifestyle Funds: Like balanced funds, these funds invest in both stocks and bonds. However, lifestyle funds create a mix of stocks and bonds that adjusts over time, becoming more conservative as a participant/investor nears retirement. There is a wide range of these products offered, and the mix of stocks and bonds for each target retirement date fund varies widely among providers.

Growth Funds: The main goal of these funds is capital appreciation – in other words, an increase in the price of the stock. Rather than paying dividends, the companies in these funds typically reinvest their earnings for expansion, research or development.

Aggressive Growth Funds: These funds are often chosen by investors with maximum capital gains as their objective. Aggressive growth funds invest in growing companies that have the potential to produce large gains. Because the companies are often start-ups or from new industries, there is more investment risk and price volatility.

Growth and Income Funds: The goal of these funds is to grow the principal, but still generate some income. They invest in earnings growth-oriented companies, as well as companies that pay dividends.

Fund of Funds: A mutual fund which invests in other mutual funds. Just as a mutual fund invests in a number of different securities, a fund of funds holds shares of many different mutual funds. Generally, these funds are designed to achieve even greater diversification than traditional mutual funds. However, it depends on the objective of the fund. However, you need to consider that each of the funds that make up a fund of funds has expenses, so be aware that total expenses can be as much as it would be if you invested in a number of different funds.

Index Funds: These funds invest in securities that make up a market index. For example, an index fund based on the Standard and Poor's 500 would invest in all or a representative sampling of the stocks that make up that index. Because securities in an index fund's portfolio rarely change, management costs are generally lower than those of actively managed funds. This is partly because trading costs are lower and because it is not necessary to pay analysts to search out investments for the fund, since the investments are selected from the index.

Value Funds: These are mutual funds that invest in companies which the portfolio manager determines are underpriced by fundamental measures. Assuming that a company's share price will not remain undervalued indefinitely, the fund looks to make money by buying before the expected upturn. Value funds tend to focus on safety rather than growth, and often choose investments providing dividends as well as capital appreciation.

With all the names mutual funds can go by, deciding which mutual funds are most appropriate for your 403(b) plan can be somewhat overwhelming. A financial advisor can take an objective look at your goals and help you develop a strategy appropriate for your goals, timeline and risk tolerance.

Be sure to read the prospectus to find out what index is being use to measure the performance of the fund you invest in, or ask your financial advisor what index he or she would recommend you use.