Investment Basics

If you tried on your own to develop a fully diversified account of stocks, bonds, treasuries and other securities, you'd probably find yourself a whole lot poorer.

Much of your investment would be eaten up by brokers' fees, which get assessed at both ends -- when you buy and when you sell. You'd have to pay custodial and clearing fees, and sort out complex tax issues. And forget about investing in any international securities; operational expenses outside the U.S. are much higher.

For these reasons, only a tiny segment of the market is made up of direct retail investors -- investors who manage their own portfolios. Most investors use "investment vehicles," which pool contributions from many sources and leave the investment decisions to professional financial companies. These include open-end mutual funds, closed-end mutual funds, institutional funds (such as funds for public employee pension plans, charitable trusts, corporate trusts, etc.), private and collective trust funds, real estate investment trusts and many other fund types.

There are many types of investment vehicles, but 401(k) investments are normally limited to mutual funds, stable value funds and, in some cases, company stock funds.

Mutual Funds

When you buy a share in a mutual fund, you're buying both a share in an investment company and a service from that company (or more accurately, the management company that sponsors it).

The service you buy is convenient and relatively inexpensive access to the capital markets. The value of your shares in the company depends on the company's profits (how well the mutual fund invests and performs in the markets).

Structure

When people refer to mutual funds, they usually mean open-end funds which can issue an unlimited number of shares. The more money investors put into the fund, the more shares it issues. There is no limit to the size of a mutual fund: Fidelity's legendary Magellan Fund has well over $50 billion in assets under management.

Funds use shareholder money to buy assets. The stocks or bonds a fund holds comprise its portfolio, and the financial professional who decides what to buy and sell is the portfolio manager.

Every day the fund's accountants calculate the value of each share. This is done by totaling up the value of all assets in the fund's portfolio and dividing that figure by the number of fund shares outstanding. The resulting number is the fund's net asset value (NAV). All fund managers share one goal -- to make the NAV go higher.

How does the mutual fund company make money?

Fund managers charge management fees, which are generally pretty small, often less than 1.5% of the money you invest. This small percentage, however, is enough to be profitable for the fund company, since so many people are investing so much money.

Types

There are four general mutual fund types:

Stock funds buy stocks. Their investment objective is usually specific to a certain stock type -- small cap, large cap, international, etc.

Bond funds hold only bonds. As with stock funds, they can be designed to purchase particular grades of bonds.

Balanced funds invest in a mix of stocks and bonds.

Money market funds stick with safe, short-term debt instruments such as commercial paper, banker's acceptances, repurchase agreements and certificates of deposit. Because they have low risk, they typically provide the lowest returns among mutual funds. Their main uses are to park money between investments, hold emergency savings and to save for short-term goals. A small investment in money markets may also reduce some risk in a long-term investment account.

Funds are usually categorized by the type of assets they invest in -- small cap stock, intermediate bond, etc.

One type of fund that bears a special mention is the Index Fund, which invests in the companies that comprise the various "indexes" (Standard & Poor's 500, Russell 2000, etc.). The fund buys a portfolio of stocks that are expected to behave almost exactly as the index does. This is called passive management, since the account doesn't change and the portfolio manager doesn't make daily investment decisions.

How to Judge Mutual Funds

Because it's not possible to predict the future, people often look at a mutual fund's historical performance to gauge how the fund might behave in times to come. While it may be tempting to focus solely on how much money the fund has earned for its investors (the return), it is also important to draw other lessons about the fund, such as the risk level of its investments, its expenses and its style of investing. However, it is important to realize that many things change over time, including market conditions and personnel working for the mutual fund. There are countless examples of funds achieving spectacularly high returns in one year only to incur equally spectacular losses in the following year.

There are many services available to track fund performance, the best-known of which is Chicago-based Morningstar Inc.

Morningstar provides data on mutual fund expenses, management objectives, major investments and historical returns. The company also provides the well-known "star" rating for funds -- one to five stars according to performance. In advertisements, fund companies love to tout high Morningstar ratings. But as with any type of numeric or thumbs-up-thumbs-down rating, you should look beyond the rating to learn more about the fund before you invest.

Stable Value Funds

These funds buy stable value contracts (often called guaranteed investment contracts or GICs) offered by insurance companies or banks.

Under the terms of these contracts, an insurance company or bank invests your money in a portfolio of fixed income investments, such as bonds and mortgages, for an agreed-upon period of time. The issuer guarantees a regular rate of return for the duration of the contract and assumes all investment risk.

If the investment returns are lower than expected, the insurance company or bank still pays the specified amount. If returns are higher, the issuer gets to keep the extra profit (that's how they make money on the deal). Stable value funds returns to investors generally tend to be a little higher than returns for Treasury securities or money market funds. Historical returns for stable value funds, as for most fixed income investments, have been lower than for equity funds.

Company Stock Funds

Company stock funds -- an arrangement that allows you to put your 401(k) assets into the stock of your own company -- account for about twenty percent of 401(k) assets nationwide, according to the consulting firm Spectrem/Access Research Inc.

Retirement planning experts, however, have some serious concerns about company stock plans, and believe it's probably not advisable to keep a large portion of your nest egg in your company's stock. For more on this, click on the "Company Stock" button.

Company stock in 401(k) plans is a hot topic right now. Senator Barbara Boxer, the California Democrat, has proposed a bill to put a 10% limit on 401(k) investments that plan trustees put into an employers' stock. In the meantime, many companies have instituted their own limits on how much 401(k) money can be invested in company stock. If your employer doesn't have such a limit, make your own.