There are two types of stocks Common and Preferred. With both types, face value is market determined. Common stocks are the most popular. They come with voting rights and the dividend can be adjusted or eliminated at will. Preferred stocks offer a permanent dividend level set at purchase and can be "Called" or bought back by the company (at a premium). In bankruptcy they are payed back before the common stock is. But the downside to Preferred stocks is no voting rights. We will be dealing with common stock in this blog.
As we discussed in part B there is a huge difference in homework between buying individual issues and funds. I do not, nor do I recommend buying individual stocks. Even professional fund managers have a hard time beating the market. From here on out we will be discussing the different types of stock (equity) funds.
Large Cap funds
Or large market capitalization are funds holding stocks of US companies that have 10 billion or more dollars of market capital. You get this number by multiplying the number of outstanding shares by the price per share. GE, Google, and Apple are examples of large cap companies.
Mid Cap funds
Or middle market capitalization are funds holding stocks of US companies that have 2-10 billion dollars of market capital. They tend to be a little more volatile than the large cap companies. Monster Beverage corp, Del monte, and American building maintenance, are examples of Mid cap companies.
Small Cap funds
Or small market capitalization are funds holding stocks of US companies that have 300 million - 2 billion dollars of market capital. They tend to be more volatile than the large or mid cap companies. The reason there can be such an upside to small cap funds is that you beat out institutional investors that have market cap minimums. Buffalo wild wings, Playboy, and Spherion, are examples of Small cap companies.
International stock funds
Funds that invest in companies outside the USA. They can invest by country, region, continent, or everything but the US.
Growth stock funds
Funds that invest in companies that are considered to have above average earning potential. Most technology companies are growth companies. You make your money when the company grows and the stock value increases. Growth stocks rarely pay out dividends due to reinvestment of the profits into the company.
Value stock funds
Funds that invest in stocks that are undervalued compared to their peers. They usually have a high dividend to attract investors.
Emerging markets stock funds
Funds that invest in companies that reside in countries that are financially progressing. The country must have a unified currency, stock exchange, and some sort of regulatory agency. The potential for for large growth is tempered by high risk.
Dividend stock funds
Funds that invest in companies that pay out high dividends. You make your money from the dividend stream not as much from growth.
There are plenty of other types of funds out there. I feel that most of them tend to be niche funds. This works against diversification. It is a lot like buying individual stocks which is a fools errand.
The biggest thing to consider when choosing funds is expenses. Low fees are a great indicator of a well run financial institution. You should never pay more than 1% per year in annual expenses (preferably under 0.6%!). If the fund is part of a 401k/403b you can accept up to 1.5%. To find a funds total annual expenses find the expense ratio in the funds prospectus. You may have to add all of the various fees listed. I have a short list of 5 companies that I buy funds from for my Roth IRA. They are Vangaurd, Ishares, Global X, Fidelity, and Morgan Stanley. You will have less choices in your 401k/403b.
Here are a few ways to buy into these types of funds.
Mutual funds
A mutual fund is a basket of funds that are actively managed by a fund manager. There is usually a minimum amount that must be invested at a time (5k is common). They have a higher expense ratio due to management costs. Mutual funds tends to cost more in capital gains and taxes. This is due to the amount of trading the fund undergoes.
Index funds
An index fund is a basket of funds that "index", follow or mimic a certain market. Index funds are cheaper because they do not require active managing. Software re-balances the fund to keep it in line with what it's indexing. Since there is much less trading in an index fund the capital gains costs are very low.
ETFs
Or exchange traded funds are index funds that are traded like stocks. There are no minimums and the low cost and tax efficiency makes them my personal favorite flavor of fund. Their only drawback (or benefit if you invest a larger sum) is that you pay the same brokerage fee if you buy 1 share or 1000. Just make sure your purchasing fees do not exceed 1%.
Here are some examples of diversification of all of your investments with an average risk tolerance.
Age 20 renter
10% Large Cap stock fund
10% Mid Cap stock fund
10% Small Cap stock fund
10% International stock fund
10% Growth stock fund
10% Value stock fund
10% Emerging market stock fund
10% REIT fund*
5% US bond fund
5% TIPS bond fund
10% Cash in a Money market account
Age 30 new home owner
8% Large Cap stock fund
8% Mid Cap stock fund
8% Small Cap stock fund
10% International stock fund
8% Growth stock fund
8% Value stock fund
10% Emerging market stock fund
10% REIT fund*
5% US bond fund
5% TIPS bond fund
5% International bond fund
5% Corporate bond fund
5% Cash in a Money market account
5% CD's
I left the International and Emerging funds alone. This helps keep your foreign exposure balanced.
Age 40 Mortgage 60% payed off.
8% Large Cap stock fund
8% Mid Cap stock fund
8% Small Cap stock fund
10% International stock fund
8% Growth stock fund
8% Value stock fund
10% Emerging market stock fund
5% US bond fund
5% TIPS bond fund
5% International bond fund
5% Corporate bond fund
5% Cash in a Money market account
5% CD's
10% Real estate value
As your home equity is established you can pull back on your REIT fund holdings. If you do not own real estate you can keep 10% in a REIT fund perpetuity.
Age 50 Mortgage 90% payed off
7% Large Cap stock fund
6% Mid Cap stock fund
6% Small Cap stock fund
10% International stock fund
6% Growth stock fund
7% Value stock fund
8% Emerging market stock fund
5% US bond fund
10% TIPS bond fund
7.5% International bond fund
7.5% Corporate bond fund
5% Cash in a Money market account
5% CD's
10% Real estate value
Age 60 House paid off
5% Large Cap stock fund
5% Mid Cap stock fund
4% Small Cap stock fund
10% International stock fund
5% Growth stock fund
5% Value stock fund
6% Emerging market stock fund
10% US bond fund
10% TIPS bond fund
10% International bond fund
10% Corporate bond fund
5% Cash in a Money market account
5% CD's
10% Real estate value
Remember to factor in all of your investment vehicles in your asset allocation. 401k/403b, Roth/IRA, Brokerage account, and Bank holdings (CD's Savings etc...) Your 401k/403b may have less choices. This may cause you to pick up the slack with your Roth/IRA. Remember, This is not an exact science. The goal is to not let any one investment class get too big.
*REIT or Real Estate Investment Trust are funds that hold investment grade mortgage backed securities (Commercial and or Residential). Don't be scared of these funds. If you buy from a quality issuer they are safe enough and a good stand in for home equity.
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