There are more mutual funds available now in the US than there are individual stocks listed on the major stock exchanges. It can be a bewildering task to figure out which funds to buy. The very first step, which is often overlooked, is to choose a strategy. There are three fundamental strategies one can use with stock mutual funds. They are:
- Augmenting an existing portfolio. An investor may have a pretty well rounded portfolio, but wants to have exposure to a certain area (say biotech stocks). A sector fund will allow the investor to ‘plug the holes’ in their portfolio.
- Building a complete, actively managed portfolio. Here an investor will choose funds that are more broadly defined, such as a value fund, or a large cap fund. Three or four funds like this will give the investor broad diversification and professional management.
- General market participation. If an investor wants to be in the market, but not try to pick winning managers and sectors, they will choose index funds. Index funds track indices such as the S&P 500 with no selecting by managers. Costs in these funds are usually the lowest available. One or two index funds is usually enough.
Can these three strategies be mixed and matched? To a limited extent. But buy too many funds, and the investor will own so many stocks they’ll end up in category 3 by default, just matching the market. If that’s all the investor is going to end up doing, they should just go straight to category 3 and save themselves some grief.