3. Your personal aversion to risk
Do you have a tendency to avoid risk … or seek it out? The more you can stomach risk, the higher your risk tolerance will be in terms of investing and the higher the potential reward.
Over longer time periods, risk and reward typically go hand-in-hand: the greater the risk you can tolerate, the greater your possible rewards. Based on your available funds, time horizon, and risk aversion, you can decide how aggressive or conservative your ideal mutual fund portfolio should be.
- Aggressive – Accepting bigger risks for the long-term potential of bigger rewards
- Moderate – Limiting risk somewhat while also limiting potential reward somewhat
- Conservative – Limiting risk while also limiting potential reward
Asset allocation is the process of buying various types of stocks, bonds, mutual funds, ETFs, or other securities in order to create a diversified investment portfolio. The relative risk and reward of a mutual fund generally depends on security type it holds. Based on the different risks associated with different types of funds, you can allocate your assets across different funds to make sure that your investment is exposed to the right amount of risk (and potential reward) for your personal financial situation.
Types of Mutual Fund Accounts
When building your mutual fund portfolio, consider the type of account in which your mutual fund investments will be held. There are three main types of accounts:
- Tax free
You can hold mutual funds in just one type, or all three. The type of account in which you choose to hold each fund should depend on the tax advantages of the account and the tax-related traits of the fund, as explained below.
With tax-deferred accounts, investors are allowed to delay paying taxes on investments they’ve made for specific purposes, such as retirement. The most common type of tax-deferred account is the traditional IRA. If you own mutual funds in a tax-deferred account such as a traditional IRA, you won’t pay taxes on the interest or dividends that the fund pays, or on the capital gains taxes the fund incurs, until you begin withdrawing from your account, usually after age 59 1/2.
Tax-free accounts let you make after-tax contributions into investment accounts that can then grow tax-free. The three most popular types of tax-free accounts are Roth IRA, 401(k), and 529 accounts (college savings).
Most general investment accounts are taxable accounts, which offer no special tax advantages.
Where to begin building your mutual fund portfolio
- optionsXpress – one of the easiest online brokerages to set up. No paper forms or signatures required.
- E*Trade – over 1,000 NO LOAD, NO FEE mutual funds available
- TradeKing – offers regular trades and broker assisted trades for only $4.95.
- tradeMonster – offers mobile trading.
- optionshouse – this is basically the least expensive online brokerage for investors.
- Zecco – has commission free trades available.