Since most investors are buying mutual funds for the long-term, and most are moderate investors that want to take some risk to get higher returns (but not a high level of risk) we’ll focus on building a portfolio for this investment objective (long-term, medium risk). Here are some of the best funds to start a long-term portfolio:
Target Date Mutual Funds: These funds invest in a mix of stocks, bonds, and cash that is appropriate for a person investing until a certain year, which is usually retirement. As the target year approaches, the fund manager will gradually decrease market risk by shifting fund assets out of stocks and into bonds and cash, which is what an individual investor would do themselves manually. Therefore, target-date mutual funds are a type of ”set it and forget it” investment that doesn’t require ongoing management. For example, if you are saving for retirement and think you may retire around the year 2035, a good choice for you might be Vanguard Target Retirement 2035 (VTTHX). Once you choose your first mutual fund, you’ll have the foundation started. You can then build upon that foundation by purchasing more shares of this fund and eventually add more funds for greater diversity.
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Mutual Funds Offer Automatic Reinvestment. An investor can easily and automatically have capital gains and dividends reinvested into their mutual fund without a sales load or extra fees. Unless you are looking for income (i.e. dividends separated and deposited into cash for income reasons), you’ll want to choose the option to reinvest dividends and capital gains. This will take advantage of compounding interest, which essentially means that the interest, dividends, and gains will go to buy more shares of your mutual funds, rather than the cash coming out and being deposited into a separate account.
Knowing Your Risk Tolerance. Before choosing funds, it’s important to know your risk tolerance—a measure of the level of fluctuation (a.k.a. volatility—ups and downs) or market risk to which you’re willing to subject your portfolio. If you are just getting started investing with mutual funds, or if you get highly anxious when your $10,000 account value falls by 10 percent (to $9,000) in a one-year period, your risk tolerance is relatively low—high-risk investments probably aren’t for you. You might consider starting with a balanced or ”hybrid” fund.
Mutual Funds Are Diversified Investments. The nature of mutual funds as pooled investments that are professionally managed means that investors generally can easily accomplish one of the most important standards of smart investing — diversification. To diversify means to spread market risk by holding a variety of several different securities, rather than just a few. Most mutual funds invest in dozens or hundreds of stocks or bonds within one portfolio. Depending upon the type of fund, this accomplishes the fundamentals of diversification with as little as one or two mutual funds. However, when building a portfolio of mutual funds, especially as investment assets and objectives grow more complex over time, investors are smart to diversify across several funds in different categories.