Do You Really Understand What You’re Investing In?

Investing doesn’t have to be complicated if you do your research first

Do you know what your investment options are?

Investing really should be the simplest wealth building activity there is. Surely all you have to do is syphon some of your wages into a mutual fund every month and forget about it, right? Unfortunately, there is a bewildering array of different strategies to choose from, some of which will suit your investing style perfectly, and some which should leave you running for the nearest investing exit.

There’s also a wide range of fund options for the retail investor to engage with, but do you really know the difference? Which type of fund best suits your investing style and which ones should you avoid? These are questions I hope to answer for you in this article, so if you want to boost your investing know-how, read on.

Index Funds

Index funds attempt to replicate the performance of a portion of the market or even of the entire market. The most widely followed index in America is the Standard and Poor’s 500 index, which consists of the 500 largest publicly traded U.S. companies on domestic stock exchanges.

Likewise, in the UK there are index funds which aim to replicate each stock market index. The biggest of these is the FTSE 100 which contains the largest 100 companies listed on the UK stock exchange by market capitalization. This is followed by the FTSE 250 (250 largest companies), FTSE 350 (350 largest companies) and the AIM (Alternative Investment Market, or the smallest listed companies). Together, these are collectively known as the FTSE All-Share.

Index funds can be based on a variety of foreign and domestic indexes. Before you invest in an index, be sure you know exactly what types of companies your chosen index consists of.

It’s widely known that index funds offer an easy, low-cost route into investing, with fees that are far lower than actively managed funds. However, some active fund managers have been proven to repeatedly beat the index over time, but at an extra cost to the investor.

Balanced Funds

Balanced funds hold both stocks and bonds. Traditionally, the proportion allocated to stocks and bonds has been close: 60/40 or 65/35, with the larger proportion held in stocks. Make sure that whatever balanced fund you choose, it does indeed divide its assets between stocks and bonds using a stated formula; otherwise, you may be purchasing a stock fund or bond fund in disguise.

Stock income funds focus their investment on high dividend yielding companies and pay out more dividends and distributions to shareholders than other types of funds. Stocks held by a stock income fund typically account for 60% to 75% of such a fund’s portfolio.

The trade-off here is that the dividend income gained by fund shareholders is often at the expense of slower growth and lower price appreciation for the fund holdings.

Growth and Income Funds

Growth and income funds hold growth and income stocks. They can also hold more bonds to generate income. These funds are designed to be less volatile than typical growth funds, and they provide some of the income traditionally found in stock income funds.

Growth funds seek to profit from capital appreciation; that is, an increase in share prices of their individual company holdings. To accomplish this, fund managers invest in companies that exhibit rising sales and earnings.

If about 90% of a growth fund’s assets are in stocks of large, established companies with a moderate rate of growth and paying high dividends, a strong degree of stability is provided, offsetting risk.

Aggressive Growth Funds

Aggressive growth funds aim for maximum gains by taking larger risks than other growth funds. Managers invest in companies with unknown potential, or by purchasing smaller companies in popular industries.

Because of this aggressive investment philosophy, the turnover rate of aggressive-growth funds can be extremely high. A disadvantage of this investing style is that high turnover can bring increased fees as the fund manager is perceived to be more active. However, research conducted over the past 20 years has shown that an increased rate of stock turnover actually hampers fund performance. As a rule, you’d be advised to avoid managers with consistently high stock turnover rates.

Sector Funds

Sector funds concentrate their portfolios in one particular industry. There are many types of sector funds, ranging from those focused on technology to others focusing on health care or the financial industry. Because these funds have a concentrated portfolio, they tend to be highly volatile. They also tend to have higher fees due to the specialised nature of the holdings within them.

Offsetting this is the potential for very impressive returns should the sector see an upswing in the market. For example, the mining sector has been very volatile over the last few years and has seen values plummet, but anyone who held onto their shares would now be seeing a huge increase in profits, up by 400% in some cases.

I hope this overview of fund types has been of use to you. There’ll be plenty more investing help and tips coming in the next few weeks, so keep checking the site for updates.


Personal finance blogger who's fanatical about financial freedom, investing and making money in the UK

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