Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 23)

Mutual Funds (part H)

by

Charles Lamson

Income Funds

Income funds seek to generate current income by investing in bonds and dividend-paying stocks. As a group, they tend to be less risky than growth funds.

On the more conservative end, income funds focus on U.S. Treasury issues and agency bonds. Many of these funds offer partial or complete tax-free income. As a rule of thumb, an investment's return will go down in relation to how much of it is tax-advantaged.

As you move up the return and risk scale, income funds focus their investment strategy on corporate bonds from blue chip companies and utilities. These funds seek higher income by moving out of primarily government issue into corporate bonds and high-paying dividend stocks.

PROCEED WITH CAUTION Income funds are favored by people in retirement because they become a source of monthly income.

Income funds that invest in foreign bonds with a mix of U.S. bonds are seeking a higher level of income than those that stick with strictly U.S. issues. These funds involve more risk and are subject to international economics and monetary policy.

At the high end of risk and potential reward are income funds that invest in low-rated (junk) bonds and municipal bonds from poorly rated communities. Because both the corporate and municipal bonds are considered at risk of default, they have to pay high rates to attract purchasers.

Income funds that generate tax-free income are suitable for persons in high tax brackets, while funds that generate taxable income are more appropriate for retired persons in lower-income tax brackets or sheltered in a retirement account.

Balanced Funds

If you have ever wanted to have your cake and eat it too, then balanced or blended or hybrid funds may be for you. These funds combine growth and income fund characters for an approach that seeks to smooth out peaks and valleys.

PROCEED WITH CAUTION Trying to achieve a balance between growth and income sometimes means you do not get much of either. Approach balance funds with caution if you are looking for market returns.

How the fund mixes the two different types of stock determines its relative risk and reward. A more aggressive balanced fund will add more growth stocks to the mix and fewer bonds and dividend-paying stocks.

For the most part, these funds seek modest gains while offering some protection in a down market. Like most conservative investments, you will not set the world on fire, but you also will not lose much sleep.

JUST A MINUTE Capital preservation is the strategy of focusing on maintaining your capital base at the expense of significant returns.

The buy-and-hold strategy is historically successful for investing purposes, but like all other strategies, it has a weakness---in this case, its exit philosophy. Buy-and-hold strategy assumes a long-term commitment that will go through ups and downs. However, what if you are in a "down" when it is time to start distributions out of your retirement plan?

Some argue that as retirement draws closer, you should be shifting into vehicles like balanced funds to protect you from any last-minute downturns,  the theory being that you want to put a floor under your assets.

This strategy targets the investor who is more concerned about capital preservation than big gains. These funds are one logical step out of the buy-and-hold strategy for people approaching retirement.

Because of the interest from bonds and dividends from income stocks, balanced funds are more appropriate for a tax-sheltered account.

Sector Funds

If balanced funds are the rocking chairs of mutual funds, sector funds are the roller-coasters. Sector funds focus their investments in one particular area, or sector, of the economy, such as technology.

Their investment strategy is almost an abhorrence to mutual funds that draw their strength from diversification. Sector funds are safer than individual stocks, but would fall in the high-risk zone by almost anyone's measure.

PROCEED WITH CAUTION Sector funds tend to be on the high-risk side because the can suffer roller-coaster results.

You can also buy sector funds that invest in specific areas of the world, such as the Pacific Rim or Latin America.

When they are hot, they are very hot; when they are not, nobody remembers their name. It is easy to look backward and spot the shooting stars. Making a correct decision about which sector fund will be the next winner is not so easy.

More so than any other mutual fund, sector funds require a close watching for signs that the sector is falling out of favor with the market. Normally, when sector funds fall, it is fast and final.

JUST A MINUTE Sector funds can be among the most risky of all mutual funds because they do not diversify their holdings.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS 158-161*

END

PROCEED WITH CAUTION

Income funds are favored by people in retirement because they become a source of monthly income.

PROCEED WITH CAUTION

Trying to achieve a balance between growth and income sometimes means you do not get much of either. Approach balance funds with caution if you are looking for market returns.

JUST A MINUTE

Capital preservation is the strategy of focusing on maintaining your capital base at the expense of significant returns.

PROCEED WITH CAUTION

Sector funds tend to be on the high-risk side because the can suffer roller-coaster results.

JUST A MINUTE

Sector funds can be among the most risky of all mutual funds because they do not diversify their holdings.