Mutual Funds And Bonds: A Beginner's Guide To Investing

Investing in mutual funds and bonds is a great way to diversify your portfolio. Mutual funds are a practical and cost-efficient way to invest in a variety of stocks, bonds, or short-term investments. Bonds, on the other hand, are a way to loan money to a company or government body in exchange for periodic interest payments. Both investment options have their own set of advantages and disadvantages, and it's important to understand these before making any financial decisions.

Mutual funds are a good option for beginners and experienced investors alike as they offer instant diversification. They are also highly liquid, meaning they are easy to buy and sell. However, it's important to be aware of the fees associated with mutual funds, as these can eat into your returns over time.

Bonds are considered a safer investment option compared to stocks as they offer lower volatility and relatively stable returns. They can be bought through a broker, an ETF, or directly from the government. The four main types of bonds are corporate, government, municipal, and zero-coupon bonds. When investing in bonds, it's crucial to consider the creditworthiness of the issuer and the interest rate risk.

Whether you choose to invest in mutual funds, bonds, or a combination of both, it's important to do your research and understand the risks and potential rewards of each option.

Understanding the different types of mutual funds and bonds

Mutual funds are an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are known by the kinds of securities they invest in, their investment objectives, and the type of returns they seek. There are four main categories of mutual funds: stock, money market, bond, and target-date funds.

Stock funds, or equity funds, invest principally in equity or stocks. They are often named for the size of the companies they invest in, such as small- , mid- or large-cap companies. They can also be named for their investment approach, such as aggressive growth, income-oriented, or value.

Money market funds invest in safe, risk-free, short-term debt instruments, primarily government treasury bills. They are low-risk investments that tend to offer better returns than savings accounts, but they are not insured by the FDIC.

Bond funds focus on investments that pay a set rate of return, such as government bonds, corporate bonds, and other debt instruments. They are typically classified as either investment-grade quality (medium-to-high-credit-quality) or below-investment-grade quality, depending on the individual bonds they invest in.

Target-date funds, or life cycle funds, are popular for retirement savings accounts. They automatically shift their risk profile to a more conservative approach as the target date, usually retirement, gets closer.

Bonds are financial instruments that investors buy to earn interest. They are debt securities issued by corporations, governments, or other organizations and sold to investors. There are several types of bonds, including:

• Corporate bonds: Fixed-income securities issued by corporations to finance operations or expansions. The risk and return of corporate bonds vary widely, reflecting the issuing company's creditworthiness.
• Treasury bonds: Long-term investments issued by governments, typically with maturities of 10, 20, or 30 years. They are backed by the government and thus considered very safe, but they offer lower yields.
• International government bonds: Debt securities issued by foreign governments. They allow investors to diversify their portfolios geographically and benefit from currency fluctuations or higher yields, but they carry additional risks such as political instability.
• Municipal bonds: Debt securities issued by states, cities, or counties to fund public projects or operations. They can provide steady interest cash flow for investors and often offer tax advantages.
• Agency bonds: Issued by government-sponsored enterprises or federal agencies. They have a high degree of safety due to their government affiliation but may carry call risk, meaning the issuer can repay the bond before the maturity date.
• Green bonds: Debt securities issued to fund environmentally friendly projects. They allow investors to support sustainability while earning interest.

Bonds typically have a low price correlation with stock markets, making them an effective tool for diversifying investment portfolios.

How to choose the right mix of stocks and bonds

When deciding on the right mix of stocks and bonds, investors need to consider their financial goals, risk tolerance, and the amount they have to invest. Stocks offer higher potential returns but come with greater risk, whereas bonds provide more stability and lower risk.

Stocks

Equity funds, which invest only in common stock, offer the biggest returns but also the highest risk. However, they are still considered less risky than investing in individual stocks as they are diversified by nature, bundling hundreds or thousands of stocks together.

Bonds

On the other hand, fixed-income funds invest in government or corporate bonds that offer fixed returns. These funds are much less risky, but investors must also be prepared to accept lower returns in most cases.

Mutual Funds

Mutual funds can invest in both stocks and bonds, and there are three main types: equity funds, fixed-income funds, and balanced funds. Balanced funds are a mix of equity and fixed-income investments, and their risk levels and return potentials fall between those of equity and fixed-income funds.

Key Considerations

When choosing the right mix, investors should consider the following:

• Diversification: Holding a diverse portfolio of stocks and bonds can help reduce risk. Bond funds, in particular, provide greater diversification than individual bonds as they invest in a variety of bonds with different maturities and credit qualities.
• Time and Effort: Investing in individual bonds requires significant time and effort to research and manage. Bond funds, on the other hand, offer professional management and are more suitable for those who want a more hands-off approach.
• Financial Goals: If you are looking for predictable returns and certainty, individual bonds may be a better option. If you seek greater diversification and are willing to accept lower returns, then bond funds are a better choice.
• Risk Tolerance: Stocks are riskier but offer higher returns, while bonds are more stable and provide fixed returns.
• Amount to Invest: Individual bonds may require a larger upfront investment compared to bond funds, which offer greater diversification with a lower minimum investment.

Ultimately, the right mix of stocks and bonds depends on an investor's financial goals, risk tolerance, and the amount they have available to invest. It is important to carefully consider these factors before deciding on the appropriate investment strategy.

The pros and cons of buying individual bonds or mutual funds/ETFs

There are pros and cons to both buying individual bonds and buying a mutual fund or ETF that invests in bonds.

Buying individual bonds

Pros

• Greater control over what's in your portfolio
• No ongoing management fees
• Predictable income stream

Cons

• Requires a greater commitment of time and financial resources
• Requires significant research and oversight
• High transaction costs
• Lack of flexibility

Buying a mutual fund or ETF

Pros

• Easier to achieve broad diversification with a lower dollar commitment
• Reduced level of research required
• More tax-efficient
• Lower expense ratios
• Greater transparency

Cons

• Less control over what's in your portfolio
• May be subject to capital gains distributions
• May be more susceptible to interest rate changes

How to research and compare mutual funds

When it comes to choosing a mutual fund to invest in, there are a plethora of options available, so it's important to do your research and compare different funds to select the right one for your investment goals. Here are some detailed steps to help you research and compare mutual funds effectively:

• Define your investment horizon: The first step is to determine your investment horizon, which is how long you plan to invest for. This will help you narrow down the types of funds to compare. For example, if you have a long-term investment horizon of 5 years or more, you would typically consider equity funds, whereas for shorter horizons of less than 3 years, debt funds might be more suitable.
• Compare long-term performance: When comparing mutual funds, it's advisable to look at their performance over the long term, such as 5-, 7-, or even 10-year returns. This is because short-term performance can be volatile, especially for equity funds, and long-term performance gives a better indication of the fund's ability to grow your wealth.
• Evaluate consistency of returns: Don't just focus on high returns; also consider the consistency of those returns. A fund that consistently delivers the same level of returns over the medium to long term is often a better choice since it increases the likelihood of achieving those returns and provides more peace of mind.
• Assess downside protection: Markets can be volatile, so it's important to choose a fund that offers good downside protection. This means that even during market corrections, your investment losses will be minimised.
• Compare to the right benchmark: When investing in actively managed funds, compare their performance to the category average returns (median returns of funds in the same category) rather than just the index they are benchmarked against. Most actively managed funds aim to beat the returns of other funds in the same category, not just match an index.
• Analyse risk measures: There are several key risk measures to consider when comparing mutual funds, including Standard Deviation, Sharpe Ratio, Sortino Ratio, Alpha, and Beta. Look at these measures collectively to understand the overall risk profile of a fund and then compare it with other funds.
• Examine portfolio details: Mutual funds provide details about the sectors and specific stocks or bonds they invest in. This information can help you understand the concentration risk of a fund. If a fund has a large portion of its portfolio invested in a specific stock, bond, or sector, it may have higher concentration risk.
• Consider specific criteria for debt funds: When comparing debt mutual funds, in addition to the above, consider the Modified Duration, which indicates the interest rate risk, and the Credit Rating of the Portfolio, which shows the financial strength of the borrowers the fund has lent to.
• Avoid common mistakes: Be cautious of comparing only short-term returns, as this data can be misleading, especially for equity funds. Also, avoid basing your decision on a single criterion, such as returns or risk. Instead, use multiple criteria, including performance consistency, risk, and portfolio details, to make a well-informed decision.

By following these steps and using tools like FundVisualizer, you can effectively research and compare mutual funds to make a choice that aligns with your investment goals and risk tolerance.

How to buy mutual fund shares

There are several ways to buy mutual fund shares, including directly from a fund provider, through an investment company, or via an online brokerage. Here is a step-by-step guide on how to buy mutual fund shares:

• Decide between active and passive funds: The first choice is to decide whether to try to beat or mimic the market. Actively managed funds are managed by professionals who research and buy with an eye toward beating the market. Passive investing, on the other hand, is a more hands-off approach where the fund simply tries to mimic the market. Passive investing is often cheaper and can deliver better results.
• Calculate your investing budget: Mutual funds usually have minimum investment amounts, which can range from $100 to $3,000. Some funds even have a $0 minimum. It's important to decide how much money you have to comfortably invest.
• Decide where to buy: You can buy mutual funds through an online brokerage, directly from the fund provider, or with a traditional financial advisor. Most investors opt for online brokerages due to their broad selection of funds and lower fees. When choosing a brokerage, consider factors such as affordability, fund choices, research and educational tools, and ease of use.
• Understand mutual fund fees: Mutual funds charge an annual fee, called an expense ratio, for fund management and other costs. This is expressed as a percentage of your investment and can range from 0.1% to 3%. Funds may also have sales charges, known as loads, which are fees paid to the broker or salesperson.
• Manage your mutual fund portfolio: Consider rebalancing your portfolio once a year to keep it in line with your diversification plan. For example, if one slice of your investments had strong gains, you might sell some of those gains and invest in another area to maintain balance.

Where to Buy Mutual Funds

There are three basic ways to purchase mutual funds online:

• Investment companies: You can buy mutual funds directly from investment companies that offer and manage them. This option usually has no sales commissions or brokerage fees, but your investment options are limited to that company's family of funds.
• Investment-cum-financial services companies: Some investment companies, like Vanguard and Fidelity, allow you to use an in-house account to buy and sell mutual funds and exchange-traded funds (ETFs) offered by other firms. However, they usually push their proprietary funds, so you may incur additional transaction fees or commissions for investing in competitor funds.
• Online brokerages: Opening an online brokerage account will likely be the most expensive option, as they typically charge transaction fees/commissions for each trade. However, they provide the biggest selection of mutual funds to choose from. Some popular online brokerages include ETRADE and Betterment.

How to Buy Mutual Funds

Once you've chosen a brokerage or investment firm and opened an account, here's how to buy mutual fund shares:

• Indicate the ticker symbol of the fund you want to buy and the amount you want to invest. Mutual funds require you to invest a set dollar amount rather than purchasing a certain number of shares.
• Indicate how you want dividend distributions handled. You can choose to use them to buy additional shares of the fund or have them deposited into your investment account as cash.
• Your trade request will remain pending until the fund's daily share value is calculated at the end of the trading day. Most mutual funds report their net asset value (NAV) by 6 p.m. ET.
• It takes between one and three business days for your trade to settle. The SEC requires it to be no longer than two business days.

Frequently asked questions