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In-depth Understanding on the Three Types of Mutual Funds


There are three common types of mutual funds. These are:
- Bond Fund
- Balanced Fund
- Equity Fund

These different types of mutual funds have diversified portfolio depending on the risk appetite of the client. Typically, the portfolio of each type are as follows:

Bond Fund ~ 90% bonds | 10% stocks
Balanced Fund ~ 50% bonds | 50% stocks
Equity Fund ~ 90% stocks | 10% bonds
Grow your money through mutual funds
Grow your money through mutual funds
Bonds can be in the form of government securities or corporate bonds. It is a way of obtaining money from the public (e.g. for government projects) and promising a percentage growth of the money. It is considered low risk especially government bonds as it is almost impossible that the government will default its own debt. The rate of return however, may not be very substantial because of its low risk nature. 

Stocks on the other hand are high risk in nature. Buying stocks is like buying a share of a certain corporation and trading it in the stock market in the hopes of earning a higher return. Therefore it is a high-risk, high-return type of investment. 

Now looking at these risk-reward ratios: the higher the risk, the higher the returns but the lower the risk, the lower the returns, we can then conclude that: 

Bond Fund - low risk, low returns (4 - 8% per year)
Balanced Fund - moderate risk, moderate returns (8 - 12% per year) 
Equity Fund - high risk, high returns (>12% per year)

Now knowing these risk-reward ratios, it can then be tempting to say, "I'd go invest then in equity funds because of its high returns." However, each type of mutual fund have different purposes and it is also important to know why and when to invest on each type. 

Understanding the risk means knowing when and how long we need to invest. For our short-term goals, we can ride bond funds to minimize the risk. And for our long-term goals, we may invest in equity funds, and to compensate the risk we need to invest in a longer time horizon to maximize its potential growth and minimize the risk. 

The challenge of most people is that in terms of investing, we are not yet financially educated and as a result we prefer the assurance of banks. Thus, all our financial goals are riding the wrong financial vehicle:

Financial goals riding the wrong financial instrument
Financial goals riding the wrong financial instrument
Long-term goals riding in short-term instruments. As noticed, banks give very minimal interest rates because it is meant for liquidity as in the case of emergencies. The banks know anytime we can withdraw our funds, thus for the sake of convenience and assurance, they give very minimal returns (<1% per year). 

The ideal set-up should then be: 
Financial goals tied up with the right financial vehicles
Financial goals tied up with the right financial vehicles
For our long-term goals such as retirement and kid's college education, equity fund can be the ideal instrument granting we have a long time investment horizon. As we know, the market can go up and down, but with a long time horizon, the ups and downs can be averaged thus maximizing its potential high growth. It is important to note also that to have a longer time investment horizon, we need to start investing early.

For medium-term goals, balanced funds can be the best instrument for this. 

And lastly for short-term goals such as the need for regular cash-flow during retirement, we can use bond funds for this purpose. We want our retirement money intact and would just like to receive regular inflows. 

To learn more about receiving regular cash-flow through bond fund read: How to be living on interest via mutual funds.

Thus a strategy for retirement can be: while we are young, invest in equity funds and by the time we retire, convert it to bond funds for capital preservation and regular inflow. 

To summarize: 

1. Bond Funds - 90% bonds, 10% stocks. Low risk, low returns. Average growth: 4-8% per year. For short-term or immediate goals. Investment horizon: 1-2 years.
2. Balanced Funds - 50% bonds, 50% stocks. Moderate risk, moderate returns. Average growth: 8-12% per year. For medium term goals. Investment horizon: 2-5 years.
3. Equity Funds - 10% bonds, 90% stocks. High risk, High returns. Average growth: >12% per year. For long-term goals. Investment horizon: >5 years.

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