Aggressive growth funds: Managers of these funds are
forever on the lookout for undiscovered, unheralded
companies, including small and undervalued companies.
The goal is to get in when the stock is cheap and realize
substantial gains as it soars skyward. That dream doesn’t
always come true. But if you’re willing to accept aboveaverage
risk, you may reap above-average gains.
Growth funds: These funds are among the mainstays of
long-term investing. They own stocks in mostly large- or
medium-sized companies whose significant earnings are
expected to increase at a faster rate than that of the rest
of the market. These growth funds do not typically pay
dividends. Several types are available, including large-,
medium-, and small-company growth funds.
Value funds: Managers of these funds seek out stocks
that are underpriced — selling cheaply, relative to the
stock’s true value. The fund’s manager believes that the
market will recognize the stock’s true price in the future.
Stock price appreciation is long term. These funds don’t
typically turn in outstanding performance when the
stock market is zooming along, but tend to hold their
value a
good deal more than growth funds when stock
prices slide. That’s why value funds are generally believed
to be good hedges to more growth-oriented mutual
funds. These funds come in large-, medium-, and smallcompany
versions.
Equity income funds: These funds were developed to
balance investors’ desires for current income with some
potential for capital appreciation. These fund managers
invest mostly in stocks — often blue chip stocks — that
pay dividends. They usually make some investments in
utility companies, which are also likely to pay dividends.
Growth and income funds: These funds seek both capital
appreciation and current income. Growth and
income are considered equal investment objectives.
International and global funds: These two funds may
sound like the same type of mutual fund, but they’re not.
International funds invest in a
portfolio of only non-U.S.
stocks (international securities). Global funds, also called
world funds, can also invest in the U.S. stock markets. In
fact, during the 1990s, many global funds handed in
remarkable performances not because of their international
stock-picking prowess, but because they concentrated
the bulk of their assets in U.S. stocks. This is a
prime example of the importance of understanding how
fund managers are investing your money. I talk more
about how to make this determination in the next section.
Sector funds: The managers of these funds concentrate
their investments in one sector of the economy, such as
financial services, real estate, or technology. Although
these types of funds may be a good choice after you’ve
already built a portfolio that matches your investment
plan, they have greater risk than almost any other type
of fund because these funds concentrate their investments
in one sector or industry.
If you’re uncomfortable with the potential for significant
losses, make sure that a sector fund only accounts for a
small percentage of your portfolio — say, less than 10%.
Remember, however, that if you invest in a balanced
portfolio, your other investments should hold their own
if only one industry is impacted.
Emerging market funds: The managers of these funds
seek out the stocks of underdeveloped countries and
economies in Asia, Eastern Europe, and Latin America.
Finding undiscovered winners can prove advantageous,
but an emerging market fund — also known as an
emerging country fund — isn’t a recommended mainstay
for new investors because of the potential for loss.
When these countries and economies suffer economic
decline, they can create significant investor losses.
Single-country funds: As their name implies, the managers
of these funds look for the stock winners of one
country. Unless you have close relatives running a country
somewhere and have firsthand knowledge about that
land’s economic prospects, you’re wise to steer clear of
these funds. The reason is simple: They have unmitigated
risk from concentration in one area. For example, when
Japan’s economy declined in 1998, it sent mutual funds
that invested exclusively in that country’s companies
tumbling by more than 50%.
Index funds: The managers of these funds invest in
stocks that mirror the investments tracked by an index
such as the Standard & Poors 500. Some of the advantages
of investing in index funds include low operating
expenses, diversification, and potential tax savings. More
than 150 funds, including growth companies, track a
variety of different indexes. Although they don’t necessarily
rely on the performance of any one company or
industry to buoy their performance, they do invest in
equities that represent a market — such as the U.S. stock
market. If and when that market dips, as the U.S. market
did by 20% in 1987, index funds can be hit pretty
hard.
Saturday, June 30, 2007
Defining Mutual Funds
A mutual fund is managed by an investment company that
invests (according to the fund’s objectives) in stocks, bonds,
government securities, short-term money market funds, and
other instruments by pooling investors’ money.
Mutual funds are sold in shares. Each share of a fund represents
an ownership in the fund’s underlying securities (the
portfolio).
By law, mutual funds must calculate the price of their shares
each business day. Investors can sell their shares at any time
and receive the current share price, which may be more or
less than the price they paid.
When a fund earns money from dividends on the securities
it invests in or makes money by selling some of its investments
at a profit, the fund distributes the earnings to shareholders.
If you’re an investor, you may decide to reinvest these distributions
automatically in additional fund shares.
A mutual fund investor makes money from the distribution
of dividends and capital gains on the fund’s investments. A
mutual fund shareholder also can potentially make money as
the fund’s share per share (called net asset value, or NAV)
increases in value.
NAV of a mutual fund = Assets
– Liabilities
÷ Number of shares in the fund
(Assets are the value of all securities in a fund’s portfolio; liabilities
are a fund’s expenses.) The NAV of a mutual fund is
affected by the share price charges of the securities in the
fund’s portfolio and any dividend or capital gains distributions
to its shareholders.
Unless you’re in immediate need of this income, which is taxable,
reinvesting this money into additional shares is an excellent
way to grow your investments.
Shareholders receive a portion of the distribution of dividends
and capital gains, based on the number of shares they own.
As a result, an investor who puts $1,000 in a mutual fund
gets the same investment performance and return per dollar
as someone who invests $100,000.
Mutual funds invest in many (sometimes hundreds of ) securities
at one time, so they are diversified investments. A diversified
portfolio is one that balances risk by investing in a
number of different areas of the stock and/or bond markets.
This type of investing attempts to reduce per-share volatility
and minimize losses over the long term as markets change.
Diversification offsets the risk of putting your eggs in one
basket, such as technology funds.
A stock or bond of any one company represents just a small
percentage of a fund’s overall portfolio. So even if one of a
fund’s investments performs poorly, 20 to 150 more investments
can shore up the fund’s performance. As a result, the
poor performance of any one investment isn’t likely to have
a devastating effect on an entire mutual fund portfolio. That
balance doesn’t mean, however, that funds don’t have inherent
risks: You need to carefully select mutual funds to meet
your investment goals and risk tolerance.
The performance of certain classes of investments — such as
large company growth stocks — can strengthen or weaken a
fund’s overall investment performance if the fund concentrates
its investments within that class. If the overall economy
declines, the stock market takes a dive, or a mutual fund
manager picks investments with little potential to be profitable,
a fund’s performance can suffer.
Unfortunately, unless you have a crystal ball, you have no
way to predict how a fund will perform, except to look at the
security’s underlying risk. If a fund has existed long enough
to build a track record through ups and downs, you can
review its performance during the last stressful market.
Fortunately for all investors, some companies use a statistical
measure called standard deviation, which measures the
volatility in the fund’s performance. The larger the swings in
a fund’s returns, the more likely the fund will slip into negative
numbers.
invests (according to the fund’s objectives) in stocks, bonds,
government securities, short-term money market funds, and
other instruments by pooling investors’ money.
Mutual funds are sold in shares. Each share of a fund represents
an ownership in the fund’s underlying securities (the
portfolio).
By law, mutual funds must calculate the price of their shares
each business day. Investors can sell their shares at any time
and receive the current share price, which may be more or
less than the price they paid.
When a fund earns money from dividends on the securities
it invests in or makes money by selling some of its investments
at a profit, the fund distributes the earnings to shareholders.
If you’re an investor, you may decide to reinvest these distributions
automatically in additional fund shares.
A mutual fund investor makes money from the distribution
of dividends and capital gains on the fund’s investments. A
mutual fund shareholder also can potentially make money as
the fund’s share per share (called net asset value, or NAV)
increases in value.
NAV of a mutual fund = Assets
– Liabilities
÷ Number of shares in the fund
(Assets are the value of all securities in a fund’s portfolio; liabilities
are a fund’s expenses.) The NAV of a mutual fund is
affected by the share price charges of the securities in the
fund’s portfolio and any dividend or capital gains distributions
to its shareholders.
Unless you’re in immediate need of this income, which is taxable,
reinvesting this money into additional shares is an excellent
way to grow your investments.
Shareholders receive a portion of the distribution of dividends
and capital gains, based on the number of shares they own.
As a result, an investor who puts $1,000 in a mutual fund
gets the same investment performance and return per dollar
as someone who invests $100,000.
Mutual funds invest in many (sometimes hundreds of ) securities
at one time, so they are diversified investments. A diversified
portfolio is one that balances risk by investing in a
number of different areas of the stock and/or bond markets.
This type of investing attempts to reduce per-share volatility
and minimize losses over the long term as markets change.
Diversification offsets the risk of putting your eggs in one
basket, such as technology funds.
A stock or bond of any one company represents just a small
percentage of a fund’s overall portfolio. So even if one of a
fund’s investments performs poorly, 20 to 150 more investments
can shore up the fund’s performance. As a result, the
poor performance of any one investment isn’t likely to have
a devastating effect on an entire mutual fund portfolio. That
balance doesn’t mean, however, that funds don’t have inherent
risks: You need to carefully select mutual funds to meet
your investment goals and risk tolerance.
The performance of certain classes of investments — such as
large company growth stocks — can strengthen or weaken a
fund’s overall investment performance if the fund concentrates
its investments within that class. If the overall economy
declines, the stock market takes a dive, or a mutual fund
manager picks investments with little potential to be profitable,
a fund’s performance can suffer.
Unfortunately, unless you have a crystal ball, you have no
way to predict how a fund will perform, except to look at the
security’s underlying risk. If a fund has existed long enough
to build a track record through ups and downs, you can
review its performance during the last stressful market.
Fortunately for all investors, some companies use a statistical
measure called standard deviation, which measures the
volatility in the fund’s performance. The larger the swings in
a fund’s returns, the more likely the fund will slip into negative
numbers.
What’s new about the Roth IRA
If your income is below $110,000 (
single) or $160,000 (married
and filing jointly), you can contribute $2,000 a year to
a Roth IRA — and this contribution is permitted even if you
participate in other pension or profit-sharing plans.
The Roth IRA, introduced in 1998, offers the benefit of taxfree
withdrawals (if you are 591⁄2 and the account has been
held at least five years). If you choose a Roth IRA, your
$2,000 contribution comes out of income you’ve already paid
taxes on (that is, earnings). That’s very different from the traditional
IRA, in which your contribution may come from
pretax earnings.
Like a traditional IRA, the funds contributed to a Roth IRA
accumulate tax-free. The big difference is that if you are 591⁄2
and have held the Roth IRA for five years, you never pay tax
on the money you withdraw. That means that the earnings
on the $2,000 you contribute annually are tax-free.
If your income is more than $
110,000 and you’re single, or
if you’re married and you and your spouse have a combined
income of over $160,000, you’re not eligible for a Roth IRA.
Another advantage of the withdrawal requirements of a Roth
IRA is that you’re not required to take your money out of a
Roth IRA when you reach 701⁄2 as you are with traditional
IRAs. In fact, you can leave the money and all the earnings
to your heirs, if you want to. This allowance enables you to
control the timing and the pace of your withdrawals from
the account, potentially allowing the funds to stay there,
growing tax-free, for more years.
Investors can contribute to both a
traditional IRA and a
Roth
IRA; however, the total contribution to the two accounts can’t
exceed the $2,000 annual limit. Many financial advisors say
that if you are young and in a low tax bracket, you should
probably open a Roth IRA and fund it with the full $2,000
every year. For most people, it’s not worth debating over the
two because only those who have relatively low incomes or
no other active retirement plans can take advantage of the
deductibility of the traditional IRA.
single) or $160,000 (married
and filing jointly), you can contribute $2,000 a year to
a Roth IRA — and this contribution is permitted even if you
participate in other pension or profit-sharing plans.
The Roth IRA, introduced in 1998, offers the benefit of taxfree
withdrawals (if you are 591⁄2 and the account has been
held at least five years). If you choose a Roth IRA, your
$2,000 contribution comes out of income you’ve already paid
taxes on (that is, earnings). That’s very different from the traditional
IRA, in which your contribution may come from
pretax earnings.
Like a traditional IRA, the funds contributed to a Roth IRA
accumulate tax-free. The big difference is that if you are 591⁄2
and have held the Roth IRA for five years, you never pay tax
on the money you withdraw. That means that the earnings
on the $2,000 you contribute annually are tax-free.
If your income is more than $
110,000 and you’re single, or
if you’re married and you and your spouse have a combined
income of over $160,000, you’re not eligible for a Roth IRA.
Another advantage of the withdrawal requirements of a Roth
IRA is that you’re not required to take your money out of a
Roth IRA when you reach 701⁄2 as you are with traditional
IRAs. In fact, you can leave the money and all the earnings
to your heirs, if you want to. This allowance enables you to
control the timing and the pace of your withdrawals from
the account, potentially allowing the funds to stay there,
growing tax-free, for more years.
Investors can contribute to both a
traditional IRA and a
Roth
IRA; however, the total contribution to the two accounts can’t
exceed the $2,000 annual limit. Many financial advisors say
that if you are young and in a low tax bracket, you should
probably open a Roth IRA and fund it with the full $2,000
every year. For most people, it’s not worth debating over the
two because only those who have relatively low incomes or
no other active retirement plans can take advantage of the
deductibility of the traditional IRA.
The key benefits of traditional IRAs
If you choose a traditional IRA, your contributions may be
tax-deductible, while your savings grow and compound taxdeferred
until you withdraw them at retirement.
In certain situations, your entire contribution to a traditional
IRA can be tax deductible, meaning that you get to subtract
Chapter 3: Understanding Mutual Funds, 401(k)s, and IRAs 29
the amount that you contribute from your income, reducing
the amount of taxes you have to pay overall.
The rules for this tax benefit are as follows:
If you’re single and don’t have an employer-sponsored
retirement plan, the full $
2,000 is deductible on your
income tax return.
If you’re single and covered by an employer-sponsored
plan, you can contribute up to $2,000 and deduct the
full amount if your annual adjusted gross income is
$30,000 or less. (Annual adjusted gross income is defined
as your gross income, less certain allowed business-related
deductions.
Deductions include alimony payments, contributions
to a Keogh plan, and in some cases, contributions
to an IRA.) If your income is between $30,000
and $40,000, the deduction is prorated. If you make
more than $40,000, you can contribute, but you get no
deduction. These numbers gradually increase to $50,000
for taking the full deduction and to $60,000 for taking
no deduction, until the year 2005.
If you’re married and file your tax returns jointly, you
have an employer-sponsored plan, and your annual
adjusted gross income is $50,000 or less, you can deduct
the full amount. The figure is prorated from $50,000 to
$60,000. After $60,000, you can’t take any deduction.
By 2007, the income allowances will increase to $80,000
for taking the full deduction and $100,000 for taking no
deduction.
If your spouse doesn’t have a retirement plan at work,
and you file a joint tax return, the spouse can deduct his
or her full $2,000 contribution until your joint income
reaches $
150,000. After that, the deduction is prorated
until your joint income is $160,000, at which time you
can’t deduct the IRA contribution.
Non-income earning spouses can also open IRAs, and
the annual contribution for a married couple filing
jointly is $4,000 or 100% of earned income, whichever
is less, with a $2,000 maximum contribution for each
spouse.
Funds generally can’t be taken from a traditional IRA before
age 591⁄2 without paying a penalty. If you take money out,
taxes and a 10% penalty are imposed on the taxable portion
of the distribution.
You can make some withdrawals without paying a penalty.
Money can be taken penalty-free if you use it for a first-time
home purchase or for higher education fees. You can also
withdraw penalty-free in the event of death or disability, or
if you incur some types of medical expenses.
After you turn age 701⁄2, you are required to take money from
your traditional IRA account, either in the form of a lumpsum
payout or a little at a time; withdrawing a little at a time
allows you to extend the benefit of the tax shelter.
tax-deductible, while your savings grow and compound taxdeferred
until you withdraw them at retirement.
In certain situations, your entire contribution to a traditional
IRA can be tax deductible, meaning that you get to subtract
Chapter 3: Understanding Mutual Funds, 401(k)s, and IRAs 29
the amount that you contribute from your income, reducing
the amount of taxes you have to pay overall.
The rules for this tax benefit are as follows:
If you’re single and don’t have an employer-sponsored
retirement plan, the full $
2,000 is deductible on your
income tax return.
If you’re single and covered by an employer-sponsored
plan, you can contribute up to $2,000 and deduct the
full amount if your annual adjusted gross income is
$30,000 or less. (Annual adjusted gross income is defined
as your gross income, less certain allowed business-related
deductions.
Deductions include alimony payments, contributions
to a Keogh plan, and in some cases, contributions
to an IRA.) If your income is between $30,000
and $40,000, the deduction is prorated. If you make
more than $40,000, you can contribute, but you get no
deduction. These numbers gradually increase to $50,000
for taking the full deduction and to $60,000 for taking
no deduction, until the year 2005.
If you’re married and file your tax returns jointly, you
have an employer-sponsored plan, and your annual
adjusted gross income is $50,000 or less, you can deduct
the full amount. The figure is prorated from $50,000 to
$60,000. After $60,000, you can’t take any deduction.
By 2007, the income allowances will increase to $80,000
for taking the full deduction and $100,000 for taking no
deduction.
If your spouse doesn’t have a retirement plan at work,
and you file a joint tax return, the spouse can deduct his
or her full $2,000 contribution until your joint income
reaches $
150,000. After that, the deduction is prorated
until your joint income is $160,000, at which time you
can’t deduct the IRA contribution.
Non-income earning spouses can also open IRAs, and
the annual contribution for a married couple filing
jointly is $4,000 or 100% of earned income, whichever
is less, with a $2,000 maximum contribution for each
spouse.
Funds generally can’t be taken from a traditional IRA before
age 591⁄2 without paying a penalty. If you take money out,
taxes and a 10% penalty are imposed on the taxable portion
of the distribution.
You can make some withdrawals without paying a penalty.
Money can be taken penalty-free if you use it for a first-time
home purchase or for higher education fees. You can also
withdraw penalty-free in the event of death or disability, or
if you incur some types of medical expenses.
After you turn age 701⁄2, you are required to take money from
your traditional IRA account, either in the form of a lumpsum
payout or a little at a time; withdrawing a little at a time
allows you to extend the benefit of the tax shelter.
Investing in Individual Retirement Accounts
An Individual Retirement Account (IRA) is a tax-saving program
(established under the Employee Retirement Security
Act of 1974) to help Americans invest for retirement. Anyone
who earns money by working can contribute up to
$2,000 a year, or 100% of your income, whichever is less. If
you don’t have access to a
401(k) or other retirement plan,
or if you’ve calculated that your current plan won’t completely
cover your retirement needs, then an IRA can help.
IRAs offer tax-deferred growth — you don’t pay any tax on it
or the money that it earns for you until you withdraw it during
retirement.
You set up your IRA on your own with a bank, mutual fund,
or brokerage firm. Like a 401(k), you can invest your IRA
money in almost anything you can think of, from aggressive
growth stocks to conservative savings accounts.
Some financial planners advise that you use your IRA for
investments that produce the highest income, such as stocks
paying high dividends, because you defer the taxes. Another
tactic is to put the IRA funds into riskier high-growth investments,
such as stocks or certain types of mutual funds,
because you don’t touch the funds until retirement and can
always switch them to safer investments as you get older.
I suggest investing in an IRA for the following reasons:
If your employer doesn’t offer a 401(k) plan
If you’ve calculated that your current retirement plan
won’t completely cover your estimated retirement needs,
consider investing in an IRA — if you qualify
To invest in high-yield investments — such as stocks
paying high dividends — because your investment dollars
are tax-deferred
To invest in higher risk investments, such as stocks and
certain mutual funds, if you don’t plan to retire for years
to come (by doing so you commit to taking the chance
of receiving higher gains for your investment dollar)
You can choose from two types of IRAs: traditional IRA and
Roth IRA
(established under the Employee Retirement Security
Act of 1974) to help Americans invest for retirement. Anyone
who earns money by working can contribute up to
$2,000 a year, or 100% of your income, whichever is less. If
you don’t have access to a
401(k) or other retirement plan,
or if you’ve calculated that your current plan won’t completely
cover your retirement needs, then an IRA can help.
IRAs offer tax-deferred growth — you don’t pay any tax on it
or the money that it earns for you until you withdraw it during
retirement.
You set up your IRA on your own with a bank, mutual fund,
or brokerage firm. Like a 401(k), you can invest your IRA
money in almost anything you can think of, from aggressive
growth stocks to conservative savings accounts.
Some financial planners advise that you use your IRA for
investments that produce the highest income, such as stocks
paying high dividends, because you defer the taxes. Another
tactic is to put the IRA funds into riskier high-growth investments,
such as stocks or certain types of mutual funds,
because you don’t touch the funds until retirement and can
always switch them to safer investments as you get older.
I suggest investing in an IRA for the following reasons:
If your employer doesn’t offer a 401(k) plan
If you’ve calculated that your current retirement plan
won’t completely cover your estimated retirement needs,
consider investing in an IRA — if you qualify
To invest in high-yield investments — such as stocks
paying high dividends — because your investment dollars
are tax-deferred
To invest in higher risk investments, such as stocks and
certain mutual funds, if you don’t plan to retire for years
to come (by doing so you commit to taking the chance
of receiving higher gains for your investment dollar)
You can choose from two types of IRAs: traditional IRA and
Roth IRA
Getting out of a 401(k)
When you retire or leave your company, you can leave your
401(k) invested as it is, roll it over into another retirement
account (such as an IRA, which I talk about in the section
“Investing in Individual Retirement Accounts,” later in this
chapter), or withdraw it. People usually face some penalties
and an income tax liability for withdrawing the money. You
can claim funds from the 401(k) without a penalty after
age 591⁄2.
When you’re in your 20s and 30s, retirement may seem
impossibly far off — so far off, in fact, that it’s hard to imagine
planning for it now. However, start saving for your retirement,
and the sooner the better. In 1998, the Social Security
Administration estimated that Social Security will provide
less than a quarter of the amount you’ll need to pay for housing,
food, and other living expenses in your retirement. If
you want to retire in comfort, you will have to provide for
yourself.
401(k) invested as it is, roll it over into another retirement
account (such as an IRA, which I talk about in the section
“Investing in Individual Retirement Accounts,” later in this
chapter), or withdraw it. People usually face some penalties
and an income tax liability for withdrawing the money. You
can claim funds from the 401(k) without a penalty after
age 591⁄2.
When you’re in your 20s and 30s, retirement may seem
impossibly far off — so far off, in fact, that it’s hard to imagine
planning for it now. However, start saving for your retirement,
and the sooner the better. In 1998, the Social Security
Administration estimated that Social Security will provide
less than a quarter of the amount you’ll need to pay for housing,
food, and other living expenses in your retirement. If
you want to retire in comfort, you will have to provide for
yourself.
Deciding where to put your 401(k) money
Most 401(k) plans offer a variety of investments, including
mutual funds, stock funds, and bond funds. Deciding which
of these investments to put your money in takes research.
You don’t have to put all your 401(k) money into one investment
vehicle. Unless your research tells you otherwise, you
should invest only a certain percentage of your money in a
high-risk investment, such as stocks. Also note that most
401(k) plans offer mutual funds whose “risk” ranges from
conservative to aggressive.
To determine what percentage of your money to invest in
stocks, many financial advisors recommend that you subtract
your age from 100. For example, if you’re 25, you should
have 75% of your 401(k) money in stocks.
mutual funds, stock funds, and bond funds. Deciding which
of these investments to put your money in takes research.
You don’t have to put all your 401(k) money into one investment
vehicle. Unless your research tells you otherwise, you
should invest only a certain percentage of your money in a
high-risk investment, such as stocks. Also note that most
401(k) plans offer mutual funds whose “risk” ranges from
conservative to aggressive.
To determine what percentage of your money to invest in
stocks, many financial advisors recommend that you subtract
your age from 100. For example, if you’re 25, you should
have 75% of your 401(k) money in stocks.
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