The Growth Engines of Investing

To learn about stock (a.k.a. equity) mutual funds, watch this 1-minute video or scroll down to read the full article

By: Robert F. Abbott, freelance writer and author

As we saw in another article, stock mutual funds represent one of the main types of mutual funds in which we can invest. They’re also called equity mutual funds; I’ll use both terms, interchangeably.

Equity funds are the growth engine for most small investors (and some big investors, too). They enjoy that status because they’re built on stocks, and stocks, in turn, are based on companies, companies that have to grow to survive.

While there is a specific subset of stock mutual funds called growth funds, in this context we’re talking about stock funds as the component that will, or should, increase your original investment. You need that growth because you want to preserve your buying power. While no one expects the kind of wild inflation seen a few decades ago, even mild inflation will erode savings that aren’t growing.

Generally, you can’t expect growth from bonds or other investment vehicles you might find in an income mutual fund. Those funds aim to preserve your capital, rather than grow it. The same might be said of money market funds, which might, or might not, even match the rate of inflation.

The kind of growth you want or need will likely dictate which type of equity mutual you choose. Given the large number of funds now available, you should be able to find something that fits your needs quite closely. And, to find that fit, we’ll look at a couple of choices.

Company size

In the investment community, this is usually expressed as market capitalization, or market cap. It refers to the size of the company, based on the number of shares it has issued multiplied by the price per share. Generally speaking, the larger company, or the larger the market cap, the safer it will be.

If you’re looking for the safest of the safe, you’ll want to focus on companies that pay dividends, and especially those that have long histories of paying dividends. Look for companies designated as Dividend Achievers or Dividend Aristocrats; they have outstanding track records. Some stock mutual funds are based on just these companies.

On the other hand, if you want really high growth potential, you’ll look at smaller cap companies and the mutual funds which carry them. From such companies come the legendary stories of buying in for pennies and cashing out for dollars. Needless to say, the risks associated with such stocks correlate with the rewards.

Investment style

This is the other major question you’ll need to address when picking a stock mutual fund. Do you want a value stock fund or a growth stock fund? A value fund is one which holds shares of companies that investors believe to be undervalued by the market, and which will eventually rise, rewarding patient investors. Good companies caught in an industry-wide slump are one example of the companies that might be described as undervalued.

On the flip side, we find growth funds, made up of companies that have grown rapidly in the recent past and are expected to continue along that path in at least the near future. Again, this happens more often among small companies.

Once more, you’ll find a correlation between risk and reward; growth companies offer more potential for gains, but also greater risk of losses. Between value and growth lies what the financial industry calls blend funds, which mix the two styles.

For both company size and investing styles, think of a spectrum for each, rather than absolutes. In terms of size, think of a continuous line that extends from very small to very large, and in terms of style, think in terms of a continuous line from value to growth. You can pick your comfort level at any point along each line.

Most investors end up somewhere in the middle, but not everyone. What matters in your selection is finding the right equity fund for your situation. Generally, the younger you are or the more established you are, the greater your risk capability. When investing for retirement, investors in their 20s can take more chances than investors in their 50s, because they have more time to recover if an investment goes bad.

In addition, equity risks can be offset to some extent by putting some of your capital into safer vehicles, such as income mutual funds, which we’ll look at next. One common planning paradigm is to match what’s called your asset allocation with your age. So, for example, a 30-year old would have 30% of her investments in bonds, income funds, or money market funds and 70% in equities or equity mutual funds. On the other hand, a 60 year old would put 60% in safe investments (bonds, income funds, money market) and only 40% in equities.

And, while we’re on the subject of time horizons, it’s worth noting that while equities have a reputation for volatility (which is to say a lot of ups and downs), they actually have been quite consistent in the long run. Here’s how Jeremy Siegel, the author of Stocks for the Long Run, puts it, “The focus of every long-term investor should be the growth of purchasing power-that is, monetary wealth adjusted for the effect of inflation. The growth of purchasing power in equities [my emphasis] not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environment over the past two centuries[my emphasis], stocks have yielded between 6.6 and 7.0 percent per year after inflation in all major subperiods. (Fourth Edition, page 11).

Stock mutual funds should have a place in almost every investment portfolio, regardless of your age or circumstances.

Next, read about Bond Mutual Funds

Mutual Fund Fact 3: 46.3% of American households owned mutual funds in 2013 (2014 Investment Company Fact Book)