Many investors diversify their portfolios by using a mix of mutual funds. These funds are often placed into one of four categories: equity, fixed income, money market, or hybrid (balanced).
Equity funds are stocks or their equivalents. Fixed income funds are government treasuries or corporate bonds. Money market funds are short-term investments in high-quality debt instruments from the government, banks, or corporations, such as corporate AAA bonds.
1. Equity Funds
Stock funds are also called equity funds. They're the most volatile. Their value can rise and fall sharply over a short time. These funds invest in publicly traded rather than privately owned companies.
Stocks often perform better over the long term than other types of investments. Stocks are traded with the expectation that a company’s future results will include greater market share, greater revenue, and higher profits.
Stocks tend to move up and down due to investors’ assessment of economic conditions and their likely impact on corporate earnings. Some investors also factor other risks into earnings, such as exposure to fines or lawsuits due to discriminating against certain workers.
Not all stock funds are the same. Some common funds include growth funds, which offer the chance for large capital appreciation but may not pay a regular dividend. These include income funds that invest in stocks that pay regular dividends.
Index funds try to mirror the performance of a particular market index, such as the S&P 500 Composite Stock Price Index. They're in the mix as well. Sector funds are included. These often focus on a certain industry segment such as finance, healthcare, or technology.
2. Fixed Income Funds
Bond funds are also known as fixed income funds. They invest in corporate and government debt with the goal of providing income through dividend payments. Bond funds are often included in a portfolio to boost your total return by providing steady income when stock funds lose value.
Just as stock funds can be organized by sector, so, too, can bond funds. They can range in risk from low, such as U.S.-backed Treasury bonds, to very risky. High-yield or "junk bonds" are thought to be highly risky. They have a lower credit rating than investment-grade corporate bonds.
Bond funds face their own risks, even though they're often safer than stock funds. The issuer of the bonds may fail to pay back their debts. There may be a chance that interest rates will rise, which can cause the value of the bonds to decline. And there is an inverse relationship between bond value and interest rates when rates fall.
There's a chance that a bond will be paid off early. The manager may not be able to reinvest the proceeds in a way that pays as high a return if this happens.
3. Money Market Funds
Money market funds have lower risks compared with other mutual funds and most other investments. They are limited by law to investing only in certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments.
Money market funds try to keep their net asset value (NAV) at a constant $1 per share. This represents the value of one share in a fund. But the NAV may fall below $1 if the fund's investments perform poorly.
The returns for money market funds are often lower than those for bond or stock funds. They're vulnerable to rising inflation. Your money would be cut by 1% if a money market fund paid a guaranteed rate of 3%, but inflation rose by 4% over the investment period.
One of the bigger concerns during the global financial crisis was potential shortfalls in money market funds. These concerns vanished with the recovery of the global economy. But investor sentiment remains a major player in the money market.
4. Hybrid Funds
The fourth type of fund, the hybrid, combines different types of funds. They can be set up to match an investor's needs. This type of fund invests in both equity and bonds. This not only gives the fund the appeal of less risk, but they often give decent returns for new investors as well. They could work well for you if you need a tailored approach.
The bonus of a hybrid fund is in the diversification of the portfolio. They allow you to allocate assets in different ways for as long as you own the fund.
Hybrid funds take on the risks of the funds in the portfolio. The fund will have a more bond-specific risk if there is a higher mix of bonds than equity, and vice versa.
Both equity and bond funds can focus on either U.S. or international holdings. Global diversification can be vital to diversification between equity, fixed income, and money markets.
An exchange-traded fund (ETF) is not a fund on its own, but rather an option that you can use.
It's a group or basket of securities that trade on an exchange. ETFs are a growing segment of options for the average investor. These are often funds with lower fees that track an index, such as the S&P 500, the Russell 2000, or even certain sectors of the economy, such as technology. ETFs offer many investment choices you may want to think about.
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any one investor. It might not be right for all investors. Investing involves risk, including the loss of principal.