The idea behind a mutual fund is simple. A mutual fund combines or pools the money it receives from individuals and institutions. Professional managers invest the money in equities, fixed-income funds or other investments, as the fund’s prospectus specifies. By participating in the retirement plan, investors buy shares in the fund. In effect, each mutual fund investor owns a percentage of the fund’s investment and shares proportionately in the fund’s investment returns. When using mutual funds for retirement, most people consider two primary types of funds — equity funds and fixed-income funds.
When you invest in an equity fund, you buy shares of ownership in companies represented in that fund. Returns on equities, also known as stocks, are earned in two ways: dividends (part of the companies’ profits distributed to shareholders) and appreciation (growth in value of the shares of companies owned by the fund). Because equities allow you to share in the growth of corporate earnings, they typically have the potential to earn more than other investments over longer periods of time. The focus is generally on capital appreciation; however, equities also tend to move up and down in value more over shorter periods of time. This up and down movement is called volatility.
These types of investments represent debt such as bond funds. Investing in a bond fund is like loaning money to issuers such as corporations or government agencies.1 Bond fund investors expect a predictable flow of interest (or income) paid by the issuers back to the funds, but since they focus on preservation of principal they may not protect against inflation. Their value can fluctuate due to interest rates and other factors. Cash investments such as those in money market funds are also considered fixed-income. Fixed-income investments tend to have less volatility than equities.
How much the value of an investment goes up and down over time is an important concept when investing. While most people don’t like the thought of this happening, it is virtually impossible to invest without some level of risk. Risk tolerance relates to how you react to these fluctuations in value. Can you tolerate an investment that may be up one day and down the next? How would you feel if a low risk investment had all positive returns, but it caused you to come up short of your goal because it didn’t keep pace with inflation?
To determine your retirement investment risk tolerance, realize there are two important issues to consider: how much risk you feel comfortable taking; and how much risk you need to take to allow you to reach your retirement income goal.
Investments with a low degree of short-term risk generally have the potential for lower long-term returns, while investments with a high degree of short-term risk often have the potential for higher long-term returns.
The length of time you have to keep the money invested in your retirement horizon is referred to as your investment time horizon. With a long-term horizon, you can ride out the volatility of equities and be more agressive with your investment choices. A short-term horizon may suggest a more conservative focus on fixed income. Also, your time horizon may not end at retirement. People who continue to keep their account actively invested after they retire may need to view their life expectancy as their time horizon.
You can diversify investments by using a fund or funds that invest in different types of securities. Diversification, also known as asset allocation, can lower your overall risk because a poor return from one fund may be offset by a higher return from another. However, diversification is not a guarantee against loss.