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Different types of stock funds
When searching for stock mutual funds, you're going to run into all sorts of names and categories. They are usually pretty broad, and funds don't always live up to their names -- but at least they give you an idea of what you are getting yourself into. Here are some of the most common categories and sub-categories.
Value fund managers look for stocks that they think are cheap on the basis of earnings power (which means they often have low price/earnings ratios) or the value of their underlying assets (which means they often have relatively low price/book ratios).
Large-cap value managers typically look for big battered behemoths who shares are selling at discounted prices. Often these managers have to hang on for a long time before their picks pan out.
Small-cap value managers typically bottom-fish for small companies (usually ones with market value of less than $1 billion) that have been shunned or beaten down by other investors.
There are a lot of different breeds of growth funds. Some growth fund managers are content to buy shares in companies with mildly above-average revenue and earnings growth, while others, shooting for monster returns, try to catch the fastest growers before they crash.
Aggressive growth fund managers are like drag-car racers who keep the pedal to the metal while taking on some sizeable risk. The result: These funds often lead the pack in average annual returns over long periods of time -- as well as over short periods when the stock market is booming -- but they also have some crack-ups along the way. Consider them only if you can afford to put away your money for at least five years and if you won't bail out when faced with downdrafts of 20 percent or more.
Growth funds also invest in shares of rapidly growing companies, but lean more toward large established names. Plus, growth managers are often willing to play it safe with cash. As a result, growth funds won't zoom as high in bull markets as their aggressive cousins, but they hold up a bit better when the market heads south. Consider them if you're seeking high long-term returns and can tolerate the normal ups and downs of the stock market. For most long-term investors, a growth fund should be the core holding around which the rest of their portfolio is built.
Small company funds
Funds within the small-company category can differ dramatically. At the T. Rowe Price New Horizons fund, for example, the manager snaps up shares of small and midsize companies with zooming profits. Meanwhile, the manager of the T. Rowe Price Small-Cap Value fund is more likely to pass on such highfliers and instead, fills his portfolio with shares of very small companies that are trading at rock-bottom valuations.
Growth and income funds, Equity income funds, Balanced funds
These three types of funds have a common goal: Providing steady long-term growth while simultaneously throwing off reliable income. They all hold some combination of dividend-paying stocks and income-producing securities, such as bonds or convertible securities (bonds or special types of stocks that pay interest but can also be converted into the company's regular shares).
Growth and income funds concentrate more than the other two on growth, so they generally have the lowest yields. Balanced funds strive to keep anywhere from 50 to 60 percent of their holdings in stocks and the rest in interest-paying securities such as bonds and convertibles, giving them the highest yields. In the middle is the equity-income class. All three types hold up better the growth funds when the market turns sour, but lag in a raging bull market.
All of these are for risk-averse investors and anyone seeking current income without forgoing the potential for capital growth.
Specialty and other types of funds
A variety of small fund categories cater to more specialized needs. For example, about three dozen so-called socially responsible funds try to avoid investing in companies that engage in objectionable behavior such as polluting the environment. The idea appeals to many investors, but it has two hitches: first, not all funds agree on what is socially responsible; second, aside from a few notable exceptions, most funds with a conscience don't perform as well as conventional funds.
There are also sector or specialty funds that, rather than diversifying their holdings, concentrate their assets in a particular sector, such as technology or health care. There's nothing wrong with that approach, as long as you remember that one year's top sector could crash the following year.