With the year 2011 approaching a trend in mutual funds became very clear. Investors were pulling money out of stock funds and scurrying to the perceived safety of bond funds. The reason: bond funds had a good track record, while stock funds had beaten investors up big time...TWICE in the "lost decade" from 2000 to 2010. Going forward it could be a big mistake to assume that the best mutual funds for 2011 and beyond will again be those that invest in fixed-income securities called bonds. Let's take a look at the nature of both types of funds.
Bond funds are often labeled as INCOME funds because their objective is to earn relatively high interest income for their investors by investing in fixed-income securities. Their second objective is conservation of principal or price stability of fund shares (safety). Stock funds are often called EQUITY funds because they invest your money in equities (stocks) in pursuit of higher total returns... with a higher degree of risk. You make money here when stock prices go up, and secondarily from dividend income. Most people have learned that the value or price of their equity funds will fluctuate, going both up and down. Many haven't learned that bond fund values fluctuate as well, even though they have an OBJECTIVE of relative price stability.
Few folks pay close attention to their mutual funds, but most know whether they are making or losing money. For example, few would know how or why they made a total return of 10% for the year in a bond fund when it only paid 3% or 4% in dividend (interest) income. Where did the rest of the profits come from? Very simply, the price of their fund shares went up over the year as interest rates in the economy fell. This has been the basic trend for years as interest rates have fallen to historical lows. As a result of falling rates the fixed-income securities in bond fund portfolios have become more attractive to investors in general - who have bid bond prices up to higher and higher levels in the open market.
In the bond funds vs. stock funds debate you could say that the former are more predictable. If the economy remains lackluster and interest rates continue to fall, bond funds could well be the best mutual funds for 2011 and in future years. On the other hand, these funds are even more predictable on the down side. If interest rates go up significantly virtually all bonds in existence will become less attractive and lose value. So will the funds that invest in them. This is one of the only iron-clad rules in investing. Another is that every investment has risk... and there is considerable risk for the unsuspecting investor in income funds when interest rates are at or near historical lows. Plus, there is little upside profit potential left. After all, how much further can interest rates fall?
Equity funds, like the stock market, have always been unpredictable from year to year. That's why these funds are required to warn investors about the risks involved when investing in them. On the other hand, over the long term they have produced profits (returns) on average of about 10% a year vs. 5% to 6% returns for income funds. Some years they have produced returns of 30%, 40% or more for investors. Another advantage is the wide variety of equity funds available to average investors: general diversified funds, international, emerging markets, and specialty funds that specialize in the gold, real estate, and natural resources sectors to name a few. Not all equity funds tank when the U.S. stock market gets knocked for a loop.
In the best mutual funds for 2011 debate of bond funds vs. stock funds here are my final thoughts for you. The average investor should invest in both. You can do this and cut your overall risk if you do the following. Avoid long-term income funds because they are very sensitive to higher interest rates. Go with intermediate-term funds for less risk. In the equity funds department diversify like crazy by including international and specialty funds in your portfolio. General diversified equity funds should be your primary holdings, but mix it up a bit. Funds that specialize in the likes of gold, real estate, and oil stocks can sometimes buck the trend in a lousy stock market.
You don't need to find the best mutual funds for 2011 and beyond in either category to be successful. You need the best collection of bond funds and stock funds that will bring your overall portfolio risk to a level you can live with.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.
Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.
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