Whether you invest in stocks or bonds, you face the risk of losing money. An independent stock fund exposes you to price changes of the stocks in the portfolio. Bond prices fluctuate based on changes in interest rates. On the other hand, a balanced fund combines stocks, bonds and money market instruments to reduce the overall risk of the portfolio even beyond the risk-reducing benefits of investing in a stock or bond fund.
Each investor is different when it comes to his tolerance for risk. A high risk tolerance means that you are willing to put your money into an investment that may lose money short-term but may offer the highest returns. An example of a risky investment is buying stock in a new technology company. Risk also applies to bonds. Junk bonds are bond offerings of risky companies. These bonds pay higher interest rates than other bonds but face the greatest chance that they become worthless.
The idea of investing in a mutual fund that invests only in stocks is to reduce risk. Well-performing stocks provide a balance to poor performers in the portfolio. In any stock-based investment, however, the opportunity for large, long-term gains is offset by the higher risk of short-term loss. For example, the T. Rowe Price Science and Technology Fund produced a return of 21.6 percent over the three years ended April 2012 but lost 2 percent in the most recent of those years.
Bond funds invest in different categories of bonds such as municipal bonds, Treasuries and corporate bonds. Bonds issued by the government are the least risky. Corporate bonds vary in risk depending on the issuer. Bond prices move in opposite direction to interest rates. As such, a bond fund may produce above-average returns but is susceptible to interest rate fluctuations. For example, Pimco's Emerging Local Bond D earned an annualized rate of return of 14 percent over the past three years but fell 11.1 percent in 2008.
A balanced fund seeks to provide moderate income and moderate capital growth. A portfolio manager takes careful consideration regarding which stocks to include in the portfolio based on their volatility relative to other stocks in the portfolio and the overall market. The balanced fund also invests in investment-grade bonds as a counterbalance to stocks in the portfolio. The ratio of stocks and bonds in the fund may change. In addition to stocks and bonds, a balanced fund includes money market instruments such as Treasury bills. The idea is to minimize the volatility within the portfolio to avoid extreme highs and lows. As such, balanced funds typically provide lower investment returns over longer time periods. For example, the Fidelity Balanced Fund provided a 6.5 percent return to investors in the year ended April 2012 and 3.3 percent over three years.
Before you decide to invest in a balanced, stock or bond fund, determine your tolerance for risk and your investment objective. If you are close to retirement age, invest in a bond fund to preserve your savings. A balanced fund provides steady growth and lower risk. If you have a higher risk tolerance and have many years before retirement, investing in a balanced fund may not provide enough of a return. You may still invest in a balanced fund but use some of your money to invest in a growth stock or a stock fund that focuses on high-growth companies.