because your principal is being repaid more years down the road.The value of bonds issued by corporations also may fluctuate with the financial fortunes of the company. When a company hits a rough patch, investors question whether their bonds will be repaid and drive the price down. When investors fear bankruptcy is a real possibility, the bonds may sell for only a fraction of the original debt or principal.
Stock funds: Stock funds invest in shares of stock issued by companies. Most funds invest in stocks of dozens of different companies. Funds typically focus on either U.S. or international companies. Stock funds are the most volatile of mutual funds and ETFs, but they also hold the promise of higher potential returns. On average, stocks have returned investors about 9 percent per year over the decades. Over short periods, however, stocks can drop significantly in value. Drops of more than 10 or 20 percent aren’t uncommon and should be expected. So don’t commit money to stock funds that you expect to need or use within the next five years. Although they’re completely liquid on a day’s notice, you don’t want to be forced to sell a stock fund during a down period and possibly lose money.You can choose to invest in stocks by making your own selection of individual stocks or by letting a mutual fund manager do the picking and managing. Researching individual stocks can be more than a full-time job. And if you choose to take this path, remember that you’ll be competing against the pros who do it full time.
Over the years, increasing numbers of investors have turned to mutual funds and ETFs for their stock market investing rather than picking and choosing individual stocks on their own. While there’s good debate about the merits of these two investment strategies, plenty of sources are pushing investors to individual stocks. For instance, many websites, online pundits, financial columnists, and media/television gurus advocate for individual stocks. For more information on mutual funds including ETFs, check out the latest edition of Investing For Dummies, by Eric Tyson (Wiley).
Comparing investments and risks
When considering how you want to invest or when studying your current investments, take a close look at the breakdown of the different types you have and their associated risks. Different combinations can give you different results. Consider these points:
Bonds and savings-type vehicles, such as money market mutual funds, deserve a spot in your portfolio. For money that you expect to use within the next couple of years or for money that you need to earn a relatively high current income from, bonds and money market funds can make great sense. Historically, such investments have produced returns from about the same as to a bit more than the rate of inflation (3 percent).
Although stocks and real estate offer investors attractive long-term returns, they can and do suffer significant short-term declines in value. Just consider what happened in the late 2000s severe stock market and real estate decline. So these investments aren’t suitable for money that you may want or need to use within the next five years. BEWARE OF MUTUAL FUND DETRACTORSPrivate money managers inevitably bash mutual funds because these funds often are their competition. Many websites and financial newsletter writers and book authors even mislead investors into thinking that picking their own stocks is the best approach to investing in the market. Among the arguments made by advocates of stock picking are the following:Most mutual funds underperform the market indexes. Most mutual funds do indeed underperform their corresponding market index. This underperformance is due to expenses. Most of the studies we have reviewed on this topic typically show that about two-thirds of funds underperform their relevant market index. However, you can’t consider this an argument for picking your own stocks. The fact of the matter is that even more individual investors underperform the market indexes (see the next point in this list). Also, you have a few simple and powerful ways to increase your mutual fund returns: Avoid costly funds and use index funds and actively managed funds run by the best managers.You make higher returns picking your own stocks. Professors Brad Barber and Terrance Odean reviewed investment club participants’ trading records and discovered that the average club actually underperformed the broad stock market average by more than 3 percent per year.An investment club from Beardstown, Illinois, wrote the book The Beardstown Ladies’ Common-Sense Investment Guide: How We Beat the Stock Market — And How You Can, Too. In it, the club members claimed that returns were averaging nearly 24 percent per year, far ahead of the stock market averages of that period. Not until years after their best-selling book was published did it come out that the club really only earned a 9 percent annualized return, which placed their returns far below the market averages. The book’s publisher, Hyperion, lost a class-action lawsuit brought on behalf of defrauded book buyers.You can control tax-related issues, such as when you when buy and sell securities and recognize taxable gains or losses. This argument has some truth to it, but you can find tax-friendly funds, including tax-managed funds, index funds, and exchange-traded funds. We discuss index funds and exchange-traded funds in this chapter.
Money market and bond investments are good places to keep emergency money that you expect to use sooner. Everyone should have a reserve of money that they can access in an emergency. Keeping about three to six months’ worth of living expenses in a money market fund is a good start. Shorter-term bonds or bond mutual funds can serve as an additional, greater (than money funds) income-producing emergency cushion.
Bonds can provide useful diversification for longer-term investing. For example, when investing for retirement, placing a portion of one’s money in bonds helps to buffer stock market declines. When investing for longer-term goals, however, some younger investors may not be interested in a significant stake (or any stake at all) in boring, old bonds. The reason: They have decades until they will tap their money and are comfortable with the risks of higher-returning investments like stocks and real estate.
Take a look at Figure 4-1, which shows the historic average returns and best and worst returns (over the past 93 years) and risks of various portfolios ranging from 100% bonds to 100% stocks. While the all-stock and stock heavy portfolios produced higher average annual returns, their worst years were much worse. A balanced portfolio produces solid long-term returns with quite a bit less risk than an all-stock portfolio.
© The Vanguard Group, Inc., used with permission
FIGURE 4-1: Comparing risks and returns of different portfolios.
Managing Investment Portfolios
When saving money for your retirement, ultimately you must select investments into which you place that money. Plenty of folks find selecting investments stressful and challenging. We’re here to remove the anxiety and help you assemble an all-star investment portfolio that will build and protect your wealth over the years ahead.
Earlier in this chapter, we discuss the spectrum of available investments and highlight the important differences among them. Ownership investments, including stocks around the world, real estate, and small business, offer the greatest potential returns but also higher risk.
We don’t explicitly discuss real estate and small business in more detail in this section except to say that for asset allocation purposes, they can fulfill a role similar to investing in stocks. For a detailed discussion of real estate and small business investment opportunities, pick up a copy of the latest edition of Eric’s best-selling book, Investing For Dummies (Wiley).
In this section, we discuss core funds — such as funds of funds, target-date funds, index funds, and exchange-traded funds — that make sense for you to consider. We also present some methods for assessing and managing your investment portfolio.
Funds of funds and target-date funds
Most fund investors feel overwhelmed by having so many choices. They understand the need to hold a diversified portfolio, but they’re not sure how to assemble one. Enter funds of funds and target-date funds. Both of these types of funds give you exposure to numerous funds within a single fund. And target-date