9. Know Your Mutual Fund Manager’s Job
One reason people make so many mistakes with their stock mutual funds is that they and their mutual fund managers have a totally different understanding of the fund manager’s job. This ends up in awful marriages and painful divorces between investors and their mutual funds. Destructive relationships batter retirement savings.
Most novice investors put money into a mutual fund with a dangerous false assumption. They assume that they hired their fund manager to make money for them, no matter what. Consequently, if they start to lose money, investors figure that their fund is a flop and that they should unload it and find a better one before all their money disappears.
The fund manager, on the other hand, is operating with a totally different mind-set. Managers don’t want to lose money, either. They tend to be fiercely competitive people who love to leave other fund managers in their dust. Yet they know there will be times when losing money is inevitable simply because of the specific job they’ve been assigned and the cycles of the market that will temporarily spoil their specialty.
This is no small matter. Fund managers are specialists hired to pick a precise type of stock and ignore all other investments. It means that some managers are expressly hired to take on huge risks with your money, and others are hired to take only modest risks. It means that if a manager’s specialty is being battered by a nasty cycle, the manager usually won’t be allowed to pull away and channel your money toward safer stocks and bonds, even when the cycle is being gracious to those alternative investment choices. You read that right: By design, your fund manager will have to shun stocks or bonds that could be moneymakers for you.
Under certain cycles of the stock market, you will lose money in particular funds no matter how brilliantly the fund manager handles stocks. That’s true even of lower-risk stock funds. All stocks get battered by cycles, but not all stocks suffer at the same time. As cycles change, sometimes the risky ones will get hurt and other times the safer ones will take the beating. In general, though, the riskiest stocks get throttled the most.
Novice investors are usually shocked to find that sometimes even the savviest stock-picking pro will fail to save a mutual fund from harm. But your fund managers assume that you know all of this. They figure that you are consciously choosing mutual funds with your eyes open and that you can distinguish one fund from another by recognizing the wacky names most people find so befuddling.
In other words, if you buy an aggressive, risk-taking fund, the manager assumes that you bought it on purpose. With more than 8,000 other funds available, you could have purchased other funds instead. So the manager takes his marching orders from you. When you bought the fund, the manager assumed that you were instructing him or her to take sizable risks for you and that you are prepared for the extreme highs and lows that come with the territory. So instead of fleeing from the strategy in the midst of a scary cycle, the manager forges ahead, completing the job that he thinks you want done and preparing you for the next upturn in the cycle.
This is why Mark, the physical therapist I mentioned in the preceding chapter, might have had a perfectly capable mutual fund manager, one worth keeping despite losing thousands of Mark’s savings. After all, the manager was doing exactly what he’d been hired to do: to buy the riskiest stocks. Mark just couldn’t stomach the ride down, even though it was part of the original bargain—a natural trade-off for the superior gains Mark had loved previously.
Everything would have been fine for Mark if he had understood what he was getting into at the outset. He could have stayed out of the dangerous fund or bought less of it, using it as spice in his investment portfolio instead of the main ingredient. With a small portion of the risky fund, he could have added larger portions of safer stock funds and bonds. The combination would have insulated his money from the brutality of the high-risk stock fund.
Because he was like most investors, however, Mark naively poured all his money into the one fund that seemed like a winner and ended up in a position he couldn’t stomach.
The Cost of Ignorance
Unfortunately, novice investors routinely repeat messes like Mark’s, and they are costing people dearly.
In 2006, a mutual fund consulting firm named Dalbar analyzed how mutual fund investors handle their money. The findings were enough to make you cry.
Over the previous 20 years, investors would have gained about 11.9 percent a year on average if they’d simply put money into a mutual fund that reflected the stock market and stayed the course. Instead, Dalbar found that people moved from fund to fund, looking for the elusive better fund. And they earned a measly 3.9 percent a year.
Take a look at this disaster in dollars: At the end of 20 years, investors would have had about $398,500 if they had invested $5,000 a year in the stock market, or what’s called the Standard & Poor’s 500, and stayed with it through thick and thin. Instead, by running away from one disappointing mutual fund after another, the ordinary mutual fund investor ended up with only about $153,100.
This is why you must know your fund manager’s job before you pick a fund. That way, you will be able to discriminate between funds and protect yourself before it’s too late. You won’t need to bolt when your fund does just what you should have expected.
I’m sure you are wondering now how a person like you can ever know what a fund manager is hired to do. It’s actually quite simple, and you don’t have to know the intricacies of the job. You merely have to pay attention to the wacky words in your mutual funds and know what they actually tell you. It’s not just gibberish. Fund names and each fund’s description usually tip you off to the risks you will take and how the fund will act in cycles.
Although there are more than 8,000 different mutual funds, you must recognize only a few specific types, or categories. Just as you gave yourself an easier task by breaking down a list of 401(k) choices into just three categories—stocks, bonds, and cash—you can now break down the stock category into a few manageable types.
When you do that, you will be able to spot what you need fast and know how to mix and match riskier and less risky stock funds so that you can whip up a hardy recipe for your retirement fund and save yourself from grief.
Focus on the Right Words
I’m talking about terms such as small cap and large cap, the stuff they throw at you in TV ads to make investing seem more complicated than it has to be. I’m not talking about company names such as Fidelity, Vanguard, American, T. Rowe Price, or hundreds of others. People get lost in those less critical words. They call me and say, “I have a fund that’s doing bad—should I get rid of it?” When I ask the name, they might say, “Fidelity.” But that’s totally deficient information.
Names such as Fidelity and American just tell you what company is running a fund. That’s not where I want you to focus. This illustration will help you understand what I mean: Picture yourself walking into a large electronics superstore. The variety of merchandise can be almost as overwhelming as a 401(k) plan. The store carries televisions, computers, camcorders, smart-phones, and so on. You are in a hurry and want to go quickly to the section of the store you need.
You want a television. So when you walk into the store, you don’t want to waste a minute. You go to the clerk by the door and ask her to point you in the right direction. Do you ask the clerk where to find the Sony? Of course not. Sony makes loads of products. If you focused on the brand name, you could bounce around the store all day, seeing everything from computers to digital cameras, and never find what you needed. With the brand name alone, the clerk wouldn’t know where to send you in the store.
What’s relevant is to ask where to find the televisions. After you get to the television section, you might want to discriminate between the Sony and Samsung brands, but the key for you is to at least find and buy a television. Even if you picked a television that was somewhat inferior to another, any one of the televisions would do the job for you—it would let you watch your favorite shows.
It’s exactly the same with mutual funds. Fidelity, Vanguard, and hundreds of other companies make dozens of mutual funds, but the key to your selection is to find a certain type of mutual fund that will do a specific job for you. That’s a small-cap fund, a large-cap fund, a bond fund, an international stock fund, and so on.
Soon you will look at a list of mutual funds and be able to focus in on a key term, such as large caps, and say instantly and with certainty, “That’s like a television. It’s what I came to buy.”
Or to go back to the investing recipe analogy I want you to keep in mind, you will look at a list of mutual funds for your 401(k) plan, ignore the brand names, and scan the list for the term large cap. When you see it, you will say to yourself, “That’s like flour, the main ingredient for cooking a solid retirement fund. I need a fairly large amount of it.” Then you will scan the list a second time, and you will say, “I see a small-cap fund. That’s like sugar. It will sweeten my retirement fund, but I have to be cautious about adding too much.”
This quick recognition will determine whether you make a lot of money or lose it. So hunt for the following words in mutual funds and know both the worst-case and best-case scenarios they can deliver. Pay serious attention to what they will do for you over many years, not just one or two. The idea is to never be taken by surprise, to know what you are getting into so that you can avoid bailing out after losing a bundle at a frightening point in a cycle.
Often you will find the few words you need buried right in the mutual fund’s name. Other times, you will have to look a little further at the description of a fund. You can always find the description in a booklet called the prospectus. There’s one for every mutual fund, and you are supposed to receive a copy whenever you buy a fund.
Unfortunately, prospectuses are written in too much legalese, so reading them from cover to cover is impossible. But in a simple paragraph, usually labeled “Investment Strategy,” you will spot the keywords I’m about to teach you.
Look for the keywords so that you will know whether you are buying flour or sugar for your retirement fund recipe. Then you will be ready for the next chapter, knowing how to mix and match all the ingredients in the right quantities so that you enjoy the brew you’ve created—even when the stock market is acting cruel.
Stocks Come in Three Sizes: Know Your Size
Three key terms in stock mutual funds relate to sizes of companies: large cap, midcap, and small cap. Don’t be put off by the word cap; it’s an abbreviation for the word capitalization. It’s simply a way of telling you how big a company is. The word doesn’t relate to how much a company sells, but rather tells you what investors think the company is worth. It’s the market value of the stock, or what all investors together are willing to pay for all the shares of stock in a company.
That might be confusing, but don’t worry about it. What matters to you as a mutual fund investor is that cap instantaneously helps you identify a category. And that is important.
Categories help us in everything we do. For example, if we are thinking about animals, the word mammal helps us start focusing on a certain type of animal. But it’s still a broad word, or category—it includes everything from dogs to lions. Knowing the specific names of the animals will clue you in to how they will behave.
Likewise, the word stocks is broad, including stocks that act more docile like dogs and those that are fierce like lions. So the fund world tells you more about stocks with more specific terms such as large cap and small cap so that you can anticipate distinct differences in the behavior of stock categories.
As stocks, large-cap stocks and small-cap stocks are somewhat alike, but with differences that increase or decrease your risks during various cycles in the market.
When you start recognizing the distinct label for stock categories, it will help you keep track of where your mutual fund manager will be hunting for stocks to buy for you and the risks he or she will take with your money.
That might not sound like much. After all, a novice investor often thinks, “A stock is a stock; I know nothing about them and just want my manager to buy me the best one.” But categories matter.
Different sizes of stocks behave differently, just as different animals, such as dogs and lions, behave differently. With stocks, those differences come out dramatically during various cycles in the market. The risks between different sizes vary a lot.
In other words, when you recognize categories of stock, you will know whether you are getting into a cage with dogs or lions. In the next chapter, I tell you how to corral dogs and lions together to remove the lion’s fury. Together they act like man’s best friend.
Using the Remainder of This Chapter
Use the next part of this chapter to become acquainted with the categories of stocks. Don’t expect to absorb the details all at once. I figure that you will familiarize yourself with categories now, learn how to mix and match them in the next chapter, and then come back to this chapter in the future whenever you need to choose a fund for an IRA, a 401(k), a college savings 529 plan, or some other kind of investment account.
As you go through the categories here, I’ve put a quick note at the end of each about how to use funds in that category. You will get complete recipes— or step-by-step models to follow—in the next chapter. But in the future as you make mutual fund choices, the quick notes in this chapter should be a fast reminder of how to use each type of mutual fund. If you have a list of 401(k) funds in hand and then compare your funds to the following list, you should be able to make choices in less than five minutes.
Also, you will see some suggested funds. The list doesn’t include every fine fund, but I’ve given you some reliable ideas for IRAs or other investment accounts. If you have a 401(k) plan, do not be dismayed if you look through my suggestions and your 401(k) funds aren’t among them. Remember, the most important job you can accomplish with your 401(k) is to use the proper categories—rather than specific funds—and then mix and match them.
That’s what you will accomplish in the next chapter. Now you learn once and for all what those wacky words are telling you.
Large-Cap U.S. Stock Funds
If you have a fund with large-cap in its name or description, your fund manager will look only at the largest companies in the nation. In other words, he or she will sort through companies that are household names, firms such as Apple, Microsoft, General Electric, Exxon, Wal-Mart, Johnson & Johnson, McDonald’s, JP Morgan, Procter and Gamble, Coca-Cola, and so on.
These are established companies that might be known as “blue chips.” They are solid firms that aren’t likely to go bankrupt. Of course, as time goes by, business conditions change and even great companies sometimes flop. Just consider firms such as Kmart, Lehman Brothers, and United Airlines, goliaths that succumbed to bankruptcy. However, it’s less likely that a large, established company will fail, compared to a small, young company that is still trying to figure out how to get customers to buy its products. Larger companies are considered safer investments than small companies—not as safe as bonds, but among stocks, they are the safest.
Your fund manager must still study them carefully to make sure that each company will be growing its profits and that the stock price will rise. But over many, many years, a mutual fund holding a broad variety of solid large company stocks is likely to behave a lot like the overall stock market—or what you might hear called the Dow Jones Industrial Average or the Standard & Poor’s 500 on the news.
Understanding Your Risks in Large Caps
Over the past 86 years, the Standard & Poor’s 500, which is just a shorthand way of referring to many of the largest stocks of the stock market, has given investors an average annual return of 9.8 percent. So with a mutual fund that invests in large stocks, you might anticipate making about 10 percent a year, on average, if you keep the fund for many years. But don’t expect it each year or even in the next 10.
Remember the past: Large-cap stocks have fallen as much as 43 percent in a year, if you go all the way back to the Depression. They also have climbed as much as 54 percent in a single year, according to Ibbotson. In the past 30 years, the largest loss in a single year was 37 percent in 2008. The largest increase was 37.6 percent.
What does that tell you? It’s not a guarantee, but if you look at your large-cap mutual fund someday and see that you have lost 10 percent, or even 30 percent, of your money, and news reports are saying that the stock market is down like that, too, you should be able to calm yourself and say, “This is within the realm of possibilities for this type of fund. I thought about this when I bought it, and history tells me that cycles will change. If I stick with it, I could still average a 10 percent return—or something like that—over the next 20 or 30 years.”
Investment professionals use history as a guide to anticipate the future. It’s not perfect or precise, but it’s all we have to go on. You should use the past for insight but realize that the future could be somewhat different. Some analysts, for example, are telling investors to expect only about 4 to 8 percent returns on stocks over the next decade as the U.S. works its way out of its debt problems.
On the other hand, at the start of the decade that began in 2000, few experts imagined what was actually going to happen. Instead of gaining any money in the stock market during a 10-year span, investors lost an average of 0.9 percent per year. Notice I used the word average. During some years in the decade, people did well. For example, in 2006, they earned about 16 percent in large-cap stocks. But when all the good years and the awful years were blended together, the good times seemed to evaporate and people averaged the 0.9 percent loss per year over the 10 years.
In other words, the outcome was very different than the 9.8 percent average that history suggests people will get in large stocks over many, many decades.
Also, keep in mind that historical averages apply to large-cap stocks in general. Your particular mutual fund might not act just like the average. Maybe yours will be a couple percentage points higher or lower than the average for funds in its category. (You should check your funds every year to make sure they are roughly on course, and I give you the tools to do so at the end of Chapter 13, “Index Funds: Get What You Pay For.”)
What’s important now is to realize that your fund isn’t going to deviate much from the average fund because the category of stocks you have tends to dictate how you will do during cycles of the market. One large-cap fund will behave much like another. Keep this in mind so that your mutual funds don’t seem so mysterious.
When large caps are popular, your fund probably will be making money. When they are unpopular, you probably will be losing money or just crawling along lethargically—not making much or losing much. You will be doing this along with people who have chosen hundreds of other large-cap funds.
Their managers might be smart, but depending on the cycle, they probably won’t be able to protect investors if it’s a losing time for large-cap stocks in general. Just as you can’t expect a dog to act like a cat, you can’t expect a large-cap fund to act like a small-cap fund or a bond fund.
Still, your fund manager will try to pick the best stocks for you out of the bunch—ones he or she hopes will give you an extra edge over the average. If the manager picks a lot of technology stocks, such as Microsoft, when tech is popular, you might do better than investors on average in the large-cap fund category. But if the manager guesses wrong about what will be popular, and stocks such as Exxon become popular, you might not do as well as the average.
What to Do with Large Caps in Your Retirement Fund
Because large caps are the most stable companies, a large-cap fund should serve as your core investment in stocks at all times. By “core,” I mean that the largest portion of your stock money should go into large caps and stay there year after year. It’s your staple, like bread in a meal.
Financial advisers frequently rely on a simple guide to determine how much of a client’s money to invest in large-cap stocks or large-cap funds. First, they channel some of their client’s money into bonds. Then they focus on the full U.S. stock market. When they consider the composition of the entire U.S. stock market, they see that large-cap stocks make up roughly 70 to 75 percent of the total. So when investing in U.S. stocks, they simply put 70 to 75 percent of an investor’s stock investments into large caps. You can do the same. I give you more guidance in Chapter 11, “Do This.”
Some Large-Cap Funds Ideas
Hundreds of large-caps funds exist, and an excellent choice is usually what’s called an index fund. You find the names of several here, and I provide more information about them in Chapter 13. I also provide a couple other well-respected fund names so that you can make comparisons. Don’t worry if you don’t see your 401(k) funds here; this list does not include all the quality funds available. Also remember that whenever you select mutual funds from any list (whether this one or a list in a magazine or newspaper or on TV), you should check them out using the techniques provided at the end of Chapter 13. Fund quality is not static; it can change over time.
For now, here are some ideas you can use as starting points when digging through thousands of funds: Vanguard 500 Index (VFINX), Oakmark (OAKMX), T. Rowe Price Blue Chip Growth Stock (TRBCX), Fidelity Growth Company Fund (FDGRX), Fidelity Contrafund (FCNTX), Sequoia (SEQUX), Vanguard Dividend Growth (DVIGX), T. Rowe Price Equity Income (PRFDX), Mairs & Power Growth Fund (MPGFX), Standard & Poor’s 500 exchange-traded fund (SPY), Fidelity Spartan Total Market Index (FSTMX), Vanguard Total Stock Market Index (VTSMX), iShares S&P 500 Index (IVV), and Fidelity Spartan S&P 500 (FUSEX).
Notice the capital letters in parenthesis. These are called the tickers, or symbols. They are a short-hand way to look up a fund on the Internet or to order one from a broker. To identify more funds, try the “gold rated funds or the fund “screener” at www.Morningstar.com or the Fund Finder at www.moneycentral.msn.com. Find it under “Investing” and “Funds.” Don’t set the finder on “Top Performers.” Being on top for a few months, or even a year, means nothing. Those with a top rating over three to five years are more reliable. But before you pick a fund from a list, also pay attention to the expense ratio and loads, which I discuss in Chapter 12, “How to Pick Mutual Funds: Bargain Shop.”
Small-Cap U.S. Stock Funds
Small-cap funds are the dessert, or the funds you use to sweeten your results. As with dessert, however, you should not rely on them for a healthy diet unless you are very young and can accept a loss as painful as 58 percent in a single year.
In their best years, nothing compares to small caps. As a group, they have climbed as high as 143 percent in a single year, but they’ve also destroyed a lot of wealth during periods when they have been unpopular. In the worst year, they’ve dropped 58 percent, according to Ibbotson Associates. Over the past 86 years, all those ups and downs have turned into an average annual return of 11.9 percent, significantly higher than that of the large companies, at 9.8 percent.
Small-cap funds invest in small companies, such as Columbia Sportswear, Revlon, Pandora, or Krispy Kreme Doughnuts. You might not think of them as small. After all, Krispy Kreme has about 700 stores in the world and sells donuts in 10,000 grocery stores and gas stations.
Remember that, when I’m talking about size, I’m talking about what investors think a company is worth, or what’s called their market cap. For small caps, that generally means companies worth about $2 billion or less. By comparison, large companies are worth about $10 billion or more.
Small companies can be fragile because they are often young or struggling and are consequently making mistakes. Their products might be hot, but if the corporate leaders can’t make the business work out right, all the excitement about what they sell might be for naught.
Consider Krispy Kreme Doughnuts. People loved the donuts, so they paid high prices for the stock in the early 2000s. Then the company had serious operating problems and legal battles with the independent business people, or franchisees, who ran many of the donut shops. Government regulators also questioned whether investors were misled with faulty financial reports. The stock, which soared in 2003 to about $49, fell below $4 and was at only $7 in early 2012. An investor who got excited about donuts and bought the stock at $49 would have lost almost all of his or her money.
Small-cap stocks have a high probability of problems. It’s an area of the stock market that can make you rich if you spot a rare winner such as Apple or Microsoft in its infancy. But more often than not, small businesses fail. They might depend on a single customer, and if that customer encounters financial trouble and goes out of business, the small company might be sunk. Likewise, if another company offers a better price than a small company, all the customers might shift their business to the competitor, and a great small company could be toast.
In addition, small companies can have trouble getting banks to loan them money, or they might have to pay higher interest to get loans. If interest payments are expensive, the small company might be short on cash and might not have enough money to make top-notch products or advertise and market them. The company might not be able to hire the best employees if it can’t afford to pay people what a large company would. A fund manager for a small-cap fund must hunt for companies that will excel, knowing full well that a number of factors could work against them.
Because small caps, such as Microsoft in its infancy many years ago, can make extraordinary gains, investors who find well-managed small-cap companies can do extremely well. But risks are especially great during downturns in the economy or during some of the cruel cycles that pound small caps for months or even years.
A large company can trim fat during economic stress, but small companies often don’t have fat to cut. Think of Wal-Mart and a neighborhood store. If people lose their jobs in a recession, they might buy less from both types of stores. Wal-Mart might have to lay off some people or cut some advertising; the neighborhood store might not even be able to pay the electric bill.
Consequently, investors should put some money into small-cap funds for the extraordinary growth that young upstarts enjoy—but they should do it with care because the downside is dramatic, too. Your fund manager must be exceptional as he or she tries to identify the great firms and survivors. Because the risks are great, avoid a steady diet of small caps. Dessert-size portions will sweeten returns over many years.
What to Do
Financial planners generally recommend that investors put about 20 to 30 percent of their U.S. stock money into smaller company stocks. The definition of “small” is somewhat imprecise, though. Often when professionals talk about small caps, they are referring to the stocks that are smaller than large ones, so medium-size companies might be included in the mix. If a financial planner focuses more specifically on small companies, the adviser might suggest putting only about 12 or 15 percent of your U.S. stock money into small-cap funds.
These are all ballpark figures. Some advisers are more liberal with daring investors, if they are confident the people won’t panic and flee small caps during a brutal cycle.
How do you know whether you should be more daring? You know that small caps have fallen close to 60 percent in a single year. So look at your money. Maybe you have $1,000. Ask yourself, “Could I stand to lose all but $400, knowing that, over the next 20 to 30 years, I will be likely to make more money after that loss than I would if I invested only in large stocks?” Then revisit the issue one more time and think of it this way: “If that $1,000 goes to $400, I won’t know at $400 whether it will turn into $200, and I won’t know when the bleeding is going to stop.” If history still comforts you, you might have the stomach to hold more small caps than the average person.
One more warning before I move on: The closer you are to retirement, the less you can afford to risk. If you are 20 and lose half your money, you can earn it back—maybe in 5 years, maybe in 15. But if you are 50, you don’t have enough working years ahead of you to keep investing new money while waiting for the old money to rebuild after a substantial loss.
Here’s an example: If you would have put $10,000 into the ordinary small-cap growth fund in March 2000, you would have lost all but $5,787 by October 2001. By March 2006, or about six years after the crash, you would have regained most, but not all, of your money. You would have had $9,707, according to mutual fund research firm Lipper.
Put that into perspective by thinking of people in various age groups. For a 20-, 30-, or 40-year-old, the effects of the crash would be about gone after six years of waiting, and there would be years ahead to enjoy the high growth that historically has come from small stocks. But if you were 60 and about to retire, having $10,000 turn into less than $6,000 would be a harrowing experience. After you stop working and stashing away new money, catching up is difficult to do. In retirement, you remove money from savings instead of adding to it. You might not have six years to let your original $10,000 come back to where it started.
Some Small Cap Ideas
Consider Royce Special Equity (RYSEX), Wasatch Small Cap Growth (WAAEX), Artisan Small Cap Value (ARTVX), T. Rowe Price Diversified Small Cap (PRDSX), Vanguard Small Cap Index (NAESX), Vanguard Small Cap Value Index (VISVX), S&P SmallCap 600 exchange-traded fund (IJR), Bogle Small Cap (BOGLX), or Russell 2000 Value exchange-traded fund (IWN).
Midcap U.S. Stock Funds
Now that you understand large and small caps, this one should be easy. These are medium-size companies, those between about $2 billion and about $10 billion in capitalization. Examples you might recognize are Saks, Black & Decker, Panera Bread, and H&R Block.
Midcaps generally are companies less vulnerable than small caps. The businesses might be more established. They still are not the goliaths that large caps are, however. Some might have been large companies at one time and stumbled.
As a group, the companies tend to be a little more risky than large caps and a little less risky than small caps.
What to Do
A financial adviser might have people put about 14 percent of their U.S. stock money into midcap stocks if that choice is available within a 401(k) plan. Until a few years ago, advisers simply focused on large and small caps, not considering midcaps as a significant category of stocks. Some advisers still don’t bother with midcaps. So if you don’t have a midcap choice in your 401(k), don’t worry about it. Instead, put some of the midcap chunk of money into your large-cap choice and put slightly more than you otherwise would into small caps.
Keep the basic makeup of the stock market in mind: It’s roughly 70 to 75 percent large caps, 14 percent midcaps, and about 12 percent small caps. Why roughly? Because different analysts see the borders between the sizes somewhat differently. For example, some say small cap companies become midcaps once they are larger than $1.5 billion in size. Others don’t consider small caps appropriate for the midcap category until the company reaches $2 billion in size. Regardless, feel free to copy the general mixture—putting roughly 70 to 75 percent of your money in large caps and 25 to 30 percent into smaller companies (roughly half of that 25 to 30 percent would go into small caps and the other half midcaps).
Some Midcap Ideas
Consider Weitz Partners Value (WPVLX), Westport (WPFRX), Longleaf Partners Small Cap (LLSCX), Fidelity Spartan Extended Market Index (FSEMX), Osterweis (OSTFX), Vanguard Mid Capitalization Index (VIMSX), or Standard & Poor’s MidCap 400 exchange-traded fund (IJH).
Recognizing the Tortoise and the Hare: Growth Versus Value
You can make money with stock mutual funds in two basic ways. You can buy funds that try to pick stocks because they are expected to be very fast winners, similar to the hare in the story the “Tortoise and the Hare.” Or you can buy funds that try to pick the slow but steady, dependable stocks, or the tortoise.
When you see a list of mutual funds, you sometimes see the word growth in the name or description. When you do, that’s the hare. The fund tries to pick stocks similar to Apple, which has grown its profits at a phenomenal pace—consequently, its stock has climbed sharply.
If instead you see the words value or maybe equity income, that’s the tortoise. The fund might pick companies such as Procter & Gamble, a company that’s been around for a long time and keeps growing, but at a slower and steadier pace than fast growers. It makes dependable products for the household, so whether the economy is weak or strong, people are going to need them—it’s a relatively dependable stock.
Stocks that grow at a startling rate can’t keep it up forever. So growth stocks tend to be hot for a while and then maybe lose their momentum or do something that disappoints investors greatly, as Netflix did in 2011. At the point when momentum fades or the growth spiral fails, stock prices often drop, leaving investors bruised. Value stocks are less exciting and can include companies that have seen better days. As a group, however, they tend to be more dependable.
In the famous story, the tortoise wins the race. In investing, academic studies have shown that the tortoise is also the winner when the race lasts for many, many years. But with stocks, the hare wins a lot of sprints—and those short spurts can be very lucrative to investors. Consequently, most financial advisers have their clients invest in some growth funds, which pick stocks that are expected to grow fast, and some value funds, which pick relatively cheap stocks that are less likely to nose-dive. Neither growth nor value is inherently good or bad; both behave very differently during market cycles.
At the end of the 1990s, investors were infatuated with growth stocks, especially technology stocks. The growth funds that contained those soaring technology stocks climbed a remarkable 40 percent a year. But in the 2000s, it was a totally different matter. Growth stocks fell close to 40 percent. Then investors got scared and didn’t want to touch the growth funds, particularly those with money-destroying technology stocks in them. As investors soured on technology stocks, they wanted the safety of the steady value stocks. The cycle had made a dramatic change, from growth being popular to growth being unpopular. With that change, value became popular.
Between February 2000 and the end of 2005, the tortoise left the hare in his dust. In other words, value stocks climbed with gusto: up 59 percent. Meanwhile, the hare was out of gas. Growth stocks lost so much money between 2000 and 2002 that investors holding them were still suffering a 38 percent loss at the end of 2005.
All these statistics can make your head spin. I present them now just so you realize that what’s hot for a while doesn’t stay hot, even though you might have the illusion at any point in time that excitement for a certain category will last forever. When investors are very confident, and love stocks, growth funds tend to soar. When they are nervous, they tend to pick safer, more dependable stocks, and then value has the edge. Yet the fate of these funds is not as simple as evaluating the confidence level of the moment. Growth funds tend to pick technology and healthcare stocks, and value funds tend to pick industrial and financial stocks, so their fate tends to depend on phases in the economy and popularity of those types of stocks at any given time.
An extreme example appeared in 2008. Value funds went from being the popular choice for three years to being the most detested of mutual funds. Why? They were stuffed with bank stocks, and people throughout the world were terrified about banks collapsing in 2008. That year, value funds plunged 45 percent.
Don’t drive yourself nuts trying to figure out whether a growth fund or a value fund will be a potential winner in any single year. Having a mixture of growth and value gives investors a chance to make tremendous gains during hot cycles but protect themselves somewhat during down cycles.
How to Recognize the Fund
A growth fund is likely to have the word growth in the name. Its name also might suggest some forward-looking idea, as in “new era.” Growth funds also often use the words aggressive or emerging.
Value funds often include companies that pay dividends because older, established companies tend to pay dividends. (Dividends are small regular payments—somewhat like an interest payment—that some companies send to stockholders.)
So a value fund’s name might include the word income to reflect the dividend payments. But if you see income, look at the description to make sure it’s talking about stocks. The word income often refers to bonds, and you won’t get the stocks you need if you buy a bond fund by mistake.
What to Do
Let’s assume that you put 50 percent of your entire stock portfolio into funds that invest in large stocks. Divide that with an equal portion in a large-cap growth fund and a similar portion in a large-cap value fund (so 25 percent large-cap growth, 25 percent large-cap value).
Do the same with small-cap stocks. Say you have 16 percent invested in small company stocks. Divide that equally into a small-cap value fund and a small-cap growth fund (8 percent each).
On the other hand, if you get nervous about losing money, sometimes cutting back on growth stocks will reduce some risk, and choosing value funds that emphasize dividend-paying stocks can help.
If you would rather not have to bother figuring out whether a fund is value or growth, look for a fund that is called a blend or core fund. Blend funds mix value and growth for you. Often 401(k) plans offer a large-cap blend fund.
Because small-cap growth funds can be so volatile, and because some research shows that small-cap value funds have had an edge during long periods, some financial planners use only small-cap core funds and small-cap value funds, not small-cap growth funds. But the decade that started in 2000 shows clearly that investors can be caught by horrible surprises in either growth or value. It’s why you hedge your bets by holding a combination of fund types instead of relying on one type.
Some Core Fund Ideas
Consider Vanguard 500 Index (VFINX), Fidelity Spartan Total Market Index (FSTMX), Schwab Total Stock Market Index (SWTSX), Primecap Odyssey Growth (POGRX), T. Rowe Price New America (PRWAX), or Yacktman (YACKX).
Check Value and Growth Funds for Worst-Case Scenarios
Still not sure whether value or growth is best for you? If you want to understand what your mutual fund is likely to do in the worst of times, go to www.morningstar.com, type in the name of the fund in the Quotes box, and, when you get to the snapshot of your fund, click on Performance. Pay particular attention to the years 2000, 2001, 2002, 2008, and 2009—five terrible years in the stock market. You can get a glimpse of the damage investors endured. It’s not a perfect look at the future, but it gives you a recent example of a major bear market. Also click on Risk Measure and notice the Bear Market Rank. (A score of 1 is best and 10 is worst.)
International Stock (Equity) Funds
When you have an international stock fund, you hire a fund manager to search the world for the best stocks for you. Perhaps the fund manager will pick Toyota in Japan or Samsung in Korea. If his or her fund looks for small foreign companies, you might not recognize the names of the businesses.
If your fund is a truly broadly “diversified” international fund—one not focused on one particular country or region—your fund manager will search for good buys on every continent. That’s the type of diversified fund that is best for investors instead of one focused on only one country or region. Find the fund by looking for the word diversified in the fund’s name or description.
Sometimes novice investors will see news about a booming economy somewhere in the world and think it has to be a great investment. But their timing tends to be atrocious. They tend to jump in after a cycle has been climbing for a long time, and then their money gets decimated.
Most investors are not ingrained enough in foreign cultures to anticipate events that can zap company profits. How your stocks perform depends on the management of particular companies, politics, and economic conditions. A change in political leadership in a country, for example, could bring about government regulations that could turn a profitable company into an unprofitable one. Competition from another country with low-cost labor could take customers away from a country that previously was known for a certain product. Reading a newspaper in the U.S. doesn’t provide a deep enough insight.
Stay away from funds that invest only in Japan, only in China, only in Latin America, or in any other single country or region unless you can tell yourself honestly that you know what will happen with the Yuan currency in China or how the next election will turn out in Venezuela. Leave those judgments up to a fund manager who travels the world to spot strong companies in places where political, regulatory, or economic conditions will help them profit. Even the pros make mistakes on these complex factors.
If you have a good fund manager for a diversified international fund, the manager might move you into Australian stocks, for example, when he or she sees potential there. Later, when growth seems to be peaking in Australia and potential emerges elsewhere, your manager might move some of your money away from the lackluster area to a region of higher potential.
As in the United States, each country or region of the world goes through economic cycles and times when local stock markets are weaker or stronger. In 1998, for example, underlying problems in overheated Asian economies suddenly became undeniable, and stocks went from red hot to scary losers fast. During just three months, Asian stocks dropped 40 percent. Yet at the same time, large European stocks climbed 35 percent.
You could have lost 40 percent of your money if you had invested only in an Asian fund then. But if you had a diversified international fund that made a practice of investing money all over the world, your European stocks would have buffered the blow you took on Asian stocks at that time. Yet like all cycles, European stocks turned weak down the road and needed buffers too. In 2011, investors became terrified that severe debt problems in Greece, Spain, Italy, Portugal, and other European countries would cause the Euro zone to collapse. Over only a two-month period, European stocks plunged 20 percent. So at that point in time, a person who had simply selected a European stock fund would have lost 20 percent of his or her money.
Although it’s tough to guess which country will be the best investment at any particular moment, investors must also be aware of another choice that can be enticing during certain cycles. When investors are given a selection of international funds, they sometimes see what are called emerging market funds. Fund managers for these funds invest in less stable countries than the United States—in places such as Russia, Brazil, China, Indonesia, India, Lebanon, Turkey, and Egypt. The economies are developing and move in fits and starts that make them volatile. They soar and crash, often with little warning to an outsider.
If you look at an emerging market fund during a hot period, it might look like the wisest investment at the time, maybe providing a 40 percent return one year. But don’t be fooled. These are volatile, and although they might be red hot for a while, they have been known to drop 80 percent.
Still, impressive growth is happening in many developing parts of the world—growth that you don’t want to miss. Franklin Templeton Investments, for example, has estimated that Asia’s middle class will make up 59 percent of the world’s $56 trillion in middle-class spending by 2030, compared to 23 percent in 2009.
Given the opportunity, plus the risk of volatility, instead of merely picking an emerging market fund, a more conservative approach is to pick a diversified international fund in which your fund manager can dabble in emerging markets. The more stable stocks the manager has in your fund will buffer any surprise disaster in a corner of the globe. Typically, the international fund manager might put 5 to 20 percent of your money into the volatile areas of the world, or emerging markets.
What to Do
Search for what is described as a diversified international fund or world fund with a manager who has been investing in foreign markets for years. This is no area for a newcomer. Check on a fund manager’s background by reading a prospectus, or the pamphlet you are given when you select funds. For an easier approach, call a toll-free number for your fund and ask about the fund manager’s background. Another easy approach is to go to www.morningstar.com, type in the name of your fund, and read the quick description under Management.
You want your manager to have at least five years of experience running your fund or an international fund just like the one you are considering. Think about it: If managers are new to the international arena, are they going to be equipped to appreciate cultural nuances?
Checking a manager’s background should actually be a part of your research on any fund. I bring it up for foreign funds, however, because some fund companies dump managers into these complex funds before they’ve had adequate experience abroad.
You can put about a third of your stock portfolio into international funds. But you should know that investment managers have been having a spirited debate about the right proportions. Some argue to invest as much as 50 percent of your portfolio outside the United States because international markets make up about 53 percent of the world’s market value. But investors such as Warren Buffett have claimed there is no need to invest any money abroad because large U.S. companies do so much business in foreign lands. Even Buffett, however, changed his mind recently as he spotted investment opportunities in other countries.
I have been persuaded by those who argue that it is worthwhile to be invested in the best companies everywhere. And although the economies of the world are intertwined, cycles will play out differently in various parts of the world. So you diversify your stocks by investing at home and abroad.
Sometimes U.S. stocks do better; other times, your foreign funds will do best. That’s the idea. Because it’s impossible to predict cycles accurately, you don’t guess. You simply keep some money in international funds at all times, just as you would use with small caps and large caps constantly.
Some International Fund Ideas
Consider Oakmark International (OAKIX), Oakmark International Small Cap (OAKEX), MSCI EAFE exchange-traded index fund (EFA), Masters’ Select International (MSILX), Tweedy Browne Global Value (TBGVX), Vanguard Total International Stock Index (VGTSX), MSCI All Country World Index ex-US (ACWX) or (CWI), Vanguard World Stock Index (VT), or Vanguard MSCI Emerging Markets (VWO).
Balanced Funds
These are easy-to-use funds that enable you to hedge your bets and cut the risk of losing money because they combine stocks and bonds for you. Although they are typically called balanced funds, they might also have a name such as asset allocation funds. Typically, they invest about 60 percent of your money in stocks and 40 percent in bonds.
Increasingly, employers are automatically depositing their employees’ 401(k) contributions into balanced funds and target-date funds, which I explain in Chapter 14, “Simple Does It: No-Brainer Investing with Target-Date Funds.”
So don’t be surprised if you look at your 401(k) plan and see your matching money, or all your 401(k) money, going into a balanced fund. This is about as simple an investing approach as you can pursue.
During good cycles in the stock market, your stocks will help you make money, but you won’t make as much money in that single fund as if you had chosen a mutual fund that invested only in stocks. During bad cycles for the stocks, your bonds will insulate you, keeping you from sharp losses.
For example, 2008 was an awful year for the stock market as people worldwide worried about a potential global depression. If your money was in mutual funds that invested only in stocks, you probably lost at least 37 percent of your money in that single year. But if you mixed stocks and bonds through a balanced fund, your losses were not nearly as extreme.
You did lose about 22 percent in a balanced fund in 2008, and, of course, that’s a painful loss. Even worse, the damage intensified over the next few months. But the balanced fund continued to mitigate some of the stock market’s damage so that you got back to even and started making money again relatively quickly.
Let’s say that you originally invested $10,000 in a balanced fund in 2007 when the stock market looked promising, and you had no inkling of the coming crash. At the scariest point in the financial crisis in 2009, you would have had only about $7,100 of your original money left in the balanced fund. That’s a lot of devastation, and you might have been worried. But if you had chosen only stocks, not a balanced fund, at the worst point in 2009, you would have had only $4,300 of your original money. The shock absorbers in the balanced fund clearly served you well.
From that point on, the balanced fund continued to help you recover from your pain. Since you had insulated yourself from some of the brutality of the stock market, your money in the balanced fund started to heal well once stocks hit bottom and began climbing again after March 2009. By the end of 2011, your balanced fund probably contained $11,800, or about $1,800 more than your original $10,000 investment.
It was certainly a better place to be than with stocks alone. If instead of a balanced fund you simply had a stock market mutual fund, your pain would have been long-lasting. By the end of 2011, the stock market mutual fund would have contained just $9,000, or $1,000 less than the original $10,000 invested.
Yet if the insulation from a balanced fund is attractive to you, it’s important to realize from the outset that sometimes that fund might be a letdown for you. During cycles when stocks are hot, people around you will be talking about gigantic gains in stocks alone. Your gains will be more modest because you took a more conservative approach.
Again, take a look at what happened in early 2009. After the stock market hit bottom in the financial crisis, it made a sharp about turn. Stocks went from being cruel to investors to being extremely generous. This typically happens after fierce destruction in the market. Between March 2009 and the end of 2011, the stock market gained 67 percent. So if you had dared to put $10,000 into a stock market mutual fund at the scariest point in 2009, a little more than 2½ years later, you would have turned that $10,000 into about $16,700. Not bad, especially after the beating the stock market had delivered before that time.
In contrast, a balanced fund would not have gained as much. During the same time period, it would have gained about 53 percent and turned $10,000 into about $15,300. Of course, that’s a pretty delightful sum. Still, it is not as large as the sum from stocks alone.
There’s a significant point here: When you use balanced funds to take some of the sting out of stock market crashes, you improve your chances of healing faster if a brutal period arrives. On the other hand, if you happen to enter a period when everyone around you is gaining huge amounts of money in stocks, do not envy their fortune and dump your balanced fund. You picked a balance fund for a reason: to reduce your risks in the destructive periods that show up in the stock market without warning. The tradeoff for that protection is to be satisfied with somewhat smaller gains when stocks are hot.
What to Do
Although I told you previously not to rely on one mutual fund alone, a balanced fund is the exception. You cannot rely on a stock fund alone because it provides too much risk. You cannot rely on a bond fund alone because it won’t grow your money enough for retirement.
However, you can hold a balanced fund alone because it is designed to be fairly well diversified. It gives you stocks and bonds, so the stocks help your money grow and the bonds insulate you from risks.
If you want a simple one-stop solution as an investor, a balanced fund could be your easy choice, although I prefer a little more diversification if you are willing to do it. A balanced fund typically doesn’t give you many, if any, international stocks or small-cap stocks. A greater variety of investments usually gives you more opportunity. So if your only easy choice for a combination of stocks and bonds is a balanced fund, by all means, don’t hesitate about using it.
But you might have access to a relatively new invention that has the entire panoply of investments in it: stocks of all sizes and from many countries, plus bonds. These so-called “target date funds” are ideal easy investments, and I’ve devoted all of Chapter 14 to them.
Some Balanced or Asset Allocation Fund Ideas
Consider Vanguard Wellesley (VWINX), Fidelity Balanced (FBALX), Dodge & Cox Balanced (DODBX), Vanguard Wellington (VWELX), Bruce (BRUFX), FPA Crescent (FPACX), T. Rowe Price Spectrum (RPSIX), or Mairs & Power Balanced (MAPOX).
REITs (Real Estate Investment Trusts)
These are funds that invest in real estate—shopping centers, warehouses, apartment buildings, office buildings, and companies that manage and finance them.
A study by Ibbotson shows that it makes sense to put a little money into REITs because they tend to act differently than stocks and bonds—maybe rising while the others are falling, or vice versa. In other words, they diversify your holdings.
Still, the ordinary person often has a huge investment in real estate through a home. So some financial planners argue that you already are diversified, without also buying a mutual fund that invests in real estate. Others insist that clients put about 5 to 10 percent of their portfolio into a REIT fund.
What to Do
If your 401(k) plan doesn’t have a REIT in it, don’t worry about it. If you do have one or are investing in an IRA, you can diversify your stock and bond investments by putting no more than 5 to 10 percent of your total portfolio into a REIT fund. REITs behave somewhat like small-cap stocks but also tend to provide a consistent stream of income from dividend payments, similar to bonds. People like dividends because they can buffer the impact of a stock decline.
Gold
Investors became infatuated with gold during the 2007–2009 financial crisis because it was the only investment other than bonds that protected investors from the wrath of the stock market. But many investment experts have had little long-term experience with gold and are debating whether people should always be holding it as a diversifier.
Although stocks lost 57 percent of people’s money in the financial crisis, gold gained 24 percent and, by the end of 2011, had climbed 100 percent. People new to gold investing assumed that there was something special about gold and that they could always count on it to be a money maker. They were making the same mistake that people made about technology stocks in the late 1990s and homes in 2005.
Gold runs in cycles just like stocks, bonds, and homes, and the losses can be intense. Up to 1980, gold had soared almost 2000 percent over seven years; then it hit $850 an ounce in 1980 and became a loser for two decades. By 1999, the price had fallen to $254 an ounce. At that point in time, no investor wanted to touch the stuff.
So if you are in the midst of a cycle when gold is glistening, you must realize that it has its cycles, too. It’s not always a one-way street, like the climb from nearly $600 an ounce in 2008 to $1,920 in September 2011. When investors realize that gold doesn’t provide a guaranteed Midas touch, but they want it to diversify their investments and to protect them from inflation and market panics, they are in the right frame of mind for holding some gold on a constant basis. An adviser typically recommends no more than 5 percent of a portfolio.
Still, beware of how to invest. Gold mining stocks are sometimes used for gold exposure in IRAs, but mining stocks often do not behave like gold itself. If you want gold exposure, the best way to get it is to buy gold bullion or a fund that invests directly in gold bullion. The SPDR Gold Trust (GLD) is the oldest and best known.
Sector or Specialty Funds
You probably won’t find these funds in a 401(k) plan. But you might make the mistake of following the herd into these in your IRA.
My advice: Stay away from them. Sector funds or specialty funds invest in only one type of business—maybe just energy, or maybe just technology, or maybe just consumer products, and so on. The common person gets lured into one of these sectors when they are hot but doesn’t have enough inside knowledge to know when to get out. In fact, even professionals lack that knowledge. It’s tough to guess when a cycle for any particular sector will start or end.
So buyer beware. You are likely to get throttled in these funds.
Instead, choose a diversified mutual fund that invests in all industries, and let your fund manager choose sectors for you. In a diversified stock fund, the fund manager is always looking for hot sectors. When he or she spots one, the manager might buy a few more stocks than usual in that sector to give your fund some extra oomph. But he or she will also be watching closely to try to get you out of the way when the party ends.
When a diversified fund makes a bet, it tends to be with a small amount of money—maybe 2 percent of the fund’s total investments. When novices do it, they jump in with both feet, a very dangerous endeavor.
Stable Value Fund
This fund is more like the bond funds or money market funds covered in the preceding chapter. It is not a substitute for a stock fund. Instead, it can be used as a temporary holding tank for cash at times when you might be nervous about both stocks and bonds—perhaps when interest rates are rising and people are losing money in bond funds.
As its name suggests, it is a stable choice. It will pay you a very low interest rate that you can count on. It might be just 3 or 4 percent.
This is not a place for young investors to stash their money on a long-term basis. It simply won’t grow enough. You might see a stable value fund as a “no-risk investment,” and it typically has been just that. But in the financial crisis, investors grew worried about them because the guarantees they provide depend on insurance, which could fail in a crisis.
There’s another risk too. Remember, the biggest risk Americans face is not having enough money for retirement. So young people must be willing to invest in stocks, despite dramatic losses. Earning just 3 or 4 percent interest in a stable value fund will present the risk of running out of money in retirement.
For a person within five years of retirement, however, a stable value fund can be appealing when both stocks and bonds are falling. But remember, if you withdraw from stocks completely while they are plunging, you won’t be positioned to grow your money when the cycle suddenly turns up.
What to Do
To provide stability in your 401(k), you might have 5 percent of your money in what’s called cash. You could consider either a stable value fund or money market fund, because they are your only cash-like options in a 401(k). Be aware, however, that neither is as safe as actual cash or a bank savings account.
If you work for an employer that automatically puts matching money into a 401(k) for you, the employer might deposit your money into either a stable value fund or a money market fund. If that occurs, it doesn’t mean that the fund is your best choice. Employers deposit money in stable value and money market funds because they are afraid to invest any of your money in stocks and risk a suit if you lose money and panic.
But you cannot count on this fund to grow your money enough for retirement. If your employer has put your money there, contact your benefits office and make a change—sign up for some stock funds and bond funds, too. The next chapter helps you with quantities.
Company Stock
You might have one choice in a 401(k) that is not a mutual fund. Your employer might give you the opportunity to buy stock in the company where you work. If so, make sure you don’t overdose on it.
One of the most frequent mistakes people make with 401(k)s is assuming that they will be safe if they invest in the company that employs them. People tend to feel more comfortable with what they think they know. So they see people going to work every day and assume that the stock in their company must be just fine.
However, looks can be deceiving with stocks. Even companies with thousands of employees around the world can end up in bankruptcy or get pummeled by a new competitor. When companies go into bankruptcy court, stocks usually become worthless.
Don’t get burned the way people did at Enron in 2001, believing that their retirement was safe with stock Wall Street loved before fraud was discovered.
What to Do
Take a lesson from the professionals who run pension funds: Because single stocks are too unpredictable, pension funds never put more than about 5 percent of their money into one stock, no matter how stupendous it looks.
If you have more than that in your 401(k), sell some of the shares and transfer the money to diversified mutual funds instead. If it’s painful to do all at once, do it in stages.
Bond Funds
Bond funds invest in bonds, which tend to be safer than stocks. For a detailed explanation, see the preceding chapter.
What to Do
Investors should hold some bonds to buffer the blows of the stock market. A classic combination of stocks and bonds puts 40 percent of the portfolio in bonds and 60 percent in stocks. Young investors don’t need to keep 40 percent in bonds unless the stock market scares them. For a brave 20- or 30-year-old, 10 to 30 percent in bonds might suffice.
Consider a well-diversified bond fund that invests in a combination of U.S. government bonds and corporate bonds. Generally, an intermediate-term bond fund is a good selection. Often there are three different diversified bond fund choices: intermediate, long term, and short term.
Intermediate means that the bonds in the fund will tend to mature in about 5 to 10 years. That makes them safer than long-term bonds, or those that might not mature for about 20 or 30 years. Bonds are considered riskier when investors must wait a long time to get their money returned to them— so 20 years is riskier than 10 years, 10 years is riskier than 5 years, and 5 years is riskier than 2 years. Short-term bond funds typically choose bonds that mature in about two years. Although that makes them less risky than intermediate bonds, they usually provide a lower return.
When interest rates climb, all three types of bond funds lose money. Long-term bond funds will lose the most and short-term funds lose the least. A solution for retirees is to buy individual U.S. Treasury bonds, rather than bond funds, and hold onto the individual bonds until they mature. When you buy individual government bonds, you only lose money in a rising interest rate environment if you decide to sell the bonds.
Ideas for Bond Funds
Consider Harbor Bond Fund (HABDX), PIMCO Total Return (PTTAX), Loomis Sayles Bond (LSBRX), Vanguard Total Bond Market Index (VBMFX), or iShares BarclaysAggregate Bonds (AGG). You can also buy individual bonds for an IRA from a broker. High-quality bonds include U.S. Treasury bonds or corporate bonds that are rated A, AA, or AAA.