Choosing mutual funds for your investment portfolio is kind of like deciding which classmates to invite to your kids' birthday parties. Some are highly active bounce-off-the-wall types, while others are better behaved and easier on the nerves. Some funds offer outstanding long-term returns, but their volatility can be stressful in the short term. Others are sober and steady, but might not give the returns you need to achieve your goals. Deciding how to divide your money between aggressive and stable funds, a skill called asset allocation, can often be a challenge.
Risk vs. Reward
Your boss is coming for dinner. Do you make your foolproof brownies for dessert or take a chance on that fancy torte recipe you found on the Internet? Investing comes down to exactly that sort of balance between risk and reward. Funds that pursue aggressive growth can give you excellent returns, but it's a bumpy ride and there's a chance of losses along the way. More conservative funds, with a heavy loading in bonds and other guaranteed vehicles, offer much less stress but their returns are lower and might not let you achieve your financial goals.
Laying the Foundation
As a young couple you're in the enviable position of having decades to grow your portfolio before you need to draw an income from it. However, at this stage your income is relatively low, and between the kids and the mortgage, you've got lots of demands on it. Take care of the basics first. Lay a sound foundation by setting aside emergency funds in a high-interest savings account, short-term CDs or a money-market fund. Set up educational funds for the kids, and pay down any excess debt. Once you've done that, you're ready to give some attention to your portfolio.
The mix of funds in your portfolio largely depends on your goals. In the early stages, you've got relatively little money to fuel your mutual funds investment. However, with decades in front of you, you can take a pretty high level of risk. Over the longer term the markets always trend upward and will probably recover from any stumbles along the way. Build most of your funds portfolio around aggressive growth, with a smaller percentage in safer, more conservative funds that weight their holdings toward bonds and similar vehicles. If you're investing outside your IRA, funds investing in tax-free municipal bonds can be an excellent choice.
Changing With the Years
Over time, as your kids get older and your needs change, your portfolio should change as well. Each passing decade will reduce your ability to tolerate risk in your portfolio, so you should reduce your funds' growth orientation as well. Many funds offer good returns but less risk by investing in more stable industries, maturer economies or larger companies. Periodically, switch more of your total investment into bond funds and other vehicles that offer more predictable returns. A common rule of thumb is that the "safe" percentage of your portfolio should equal your age.
Time and Personality
There aren't any hard and fast rules about allocating your assets between different types of funds. The closer you get to retirement, the less it makes sense to gamble on high-risk, high-return funds. A five-year drop in the markets means little when you're 25, but at 65 it can put a major crimp in your lifestyle. Personality is also an important factor in the decision-making process. If you have the risk tolerance of a riverboat gambler, your portfolio will probably be heavy on growth funds. On the other hand, if every dip in your funds gives you ulcers, you should probably minimize your exposure to equities.
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