Investing 101

Many investors who manage their own portfolios make common mistakes that lead them to the false conclusion "It's impossible to make any money in the stock market." These mistakes include:

• failure to establish clear objectives
• selecting securities that are not consistent with your objectives
• purchasing too many or too few securities
• taking profits too soon
• failing to minimize losses promptly
• buying a stock based on a "tip" rather than investigating its merits
• not adjusting to changing market cycles
• not fully exploring alternative investments
• failing to follow a disciplined approach

Most investors don't have the time or expertise to search through the thousands of investment possibilities to select a portfolio that suits their individual needs. Professionally managed portfolios make investing easier. Instead of selecting individual stocks or bonds, these investments let you pool your money with that of other investors in a managed account. During the past 15 years, mutual funds and other types of investment pools have gained enormous popularity. These investments have several characteristics in common-small initial investment, diversification, liquidity and professional management.

For a management fee and a sales charge, mutual fund managers pool investors' money and invest it in various securities. Whether you plan to invest a little or a lot, you'll find mutual funds in many varieties based on investment objectives and risk tolerance. Here are the broad categories:

Income funds seek high current income by investing in securities paying high dividends, such as government and corporate bonds, utilities and high-dividend stocks. Because of their high income, these funds are somewhat insulated from some of the stock market's volatility, although they are sensitive to interest rate changes.

Growth funds, which seek capital appreciation by investing in large, well-established companies, are often called "blue chip" funds. Most pay dividends, although income is usually a secondary consideration.

Aggressive growth funds strive for maximum capital appreciation and are often considered the riskiest of equity funds. They may concentrate on selecting small company growth stocks or may use speculative techniques to obtain high profits. The greater the potential profit, the greater the risk.

Balanced funds strive to minimize risk by allocating dollars to stocks, bonds and cash. They usually invest in higher-grade securities and are appropriate for investors who want a good return with lower risk.

International and global funds allow individuals to invest in markets outside the United States and in foreign securities that trade on foreign exchanges. While global funds may invest in both U.S. and foreign securities, international funds deal exclusively in securities outside the United States. Both types of funds increase in value when the dollar falls, allowing investors to benefit from changing trends abroad.

Total return funds seek long-term appreciation through a combination of dividends and capital gains. They often appear in long-term retirement and education portfolios.

Bond funds have several different approaches and can be divided into four classes: taxable, tax-free, high-quality and high-yield. They may include taxable, tax-free, U.S. government, foreign government, corporate or any combination of bonds. They may also vary in the maturities of bonds selected.

Bond fund share prices move in the opposite direction of interest rates. As with all bonds, when interest rates rise, share prices fall. In addition, the longer the maturity of the issues in a bond fund, the more volatile the share price.

Money market funds invest in short-term IOUs from industry and government. Interest is usually accrued daily and often credited monthly. Some allow you to write checks on the balance of the account. These funds are designed to have no price volatility, but this is not guaranteed or insured by the U.S. government, and there can be no assurance that the fund will be able to maintain a stable net asset value.

Specialized or sector funds concentrate their investments in a particular industry or region, such as health care, utilities, precious metals, technology or the Pacific Rim. Since they aren't diversified outside the particular area selected, these funds can be more volatile than diversified investments.

Regardless of the type of mutual fund selected, you should always request a prospectus from the investment company to learn more about the fund before investing. Mutual funds should be regarded as long-term investments, with a time frame of at least three to five years.

One final note on mutual funds: Many investors make the mistake of chasing last year's hottest fund, and that's what it turns out to be-last year's best. Probably more important than the individual stocks, bonds or funds selected is the percentage of your portfolio dedicated to each asset class. This is when a financial advisor comes in handy.

This article was originally published in the January 1996 print edition of Entrepreneur with the headline: Investing 101.