It’s no accident that most of the funds offered in a typical 401(k) plan are stock funds. There are more stock funds, and more varieties of them, than any other type of fund. In addition, in many — though not all — years, stock funds have provided stronger investment returns than other types of funds.

Stock fund returns reflect the performance of the stocks in publicly traded companies that are the underlying investments of these funds. The portfolios of managed funds include stock in companies the manager expects to be most effective in meeting the fund’s investment objectives. Index fund portfolios, in contrast, typically include all the stocks in the index the fund tracks.

The fund as investor

 A stock fund buys in much bigger quantities than you and other individuals do, and typically buys and sells at a faster pace. But it chooses its investments for the same reasons:

  • Many funds choose stocks so they can make money by selling them at a higher price than they paid
  • Some funds choose stocks to earn dividends that the corporation pays its stockholders

Stock funds are also known as equity funds. Equity means ownership, and when a fund buys shares of stock it is buying partial ownership of the corporation issuing the stock.

What stocks do stock funds buy?

Stock funds are designed to suit different investment goals. Some make relatively conservative investments by concentrating on well-established companies sometimes described as blue chips. Their goal is steady if sometimes modest growth in value over the long term, dividend payments that can be reinvested, and limited risk from major losses resulting from business failures. These funds may have names like Blue Chip, Growth and Income, Dividend Growth, or Equity Income.

At the other end of the spectrum, some stock funds, with names like Aggressive Growth, Capital Appreciation, or almost any word combined with New or Discovery, tend to invest in younger companies that managers believe have the potential to be much more valuable in the future than they are today. Because they’re often start-ups or unproven companies, there’s also a significant risk that some of them may fail, which puts your capital at risk.

Between these extremes are thousands of other funds, some investing in a broad range of companies and others more narrowly focused on stocks in a single industry or sector.

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Matters of market capitalization

Stock funds are sometimes identified as large-cap, mid-cap, or small-cap. That’s because funds are designed to invest in companies of different sizes, identified by their market capitalizations, or market caps. You figure a company’s market cap by multiplying the current price of its stock by the number of existing shares. The dollar value that defines a company as large or small isn’t official, and it varies. Some consider companies valued at more than $5 billion to be large caps. Others set the minimum at $10 billion.

Stock Funds

Market cap makes a difference in the way a fund’s underlying investments can be expected to perform, which has a direct impact on the performance of the fund itself. Generally, the smaller the average market capitalization of the companies in a fund, the more volatile the stock price. So when you invest in a small-cap fund, you can expect greater risk but also the potential for greater return.

Market cap makes a difference in the way a fund’s underlying investments can be expected to perform, which has a direct impact on the performance of the fund itself. Generally, the smaller the average market capitalization of the companies in a fund, the more volatile the stock price. So when you invest in a small-cap fund, you can expect greater risk but also the potential for greater return.

That’s because the smaller the company, the fewer financial reserves it’s likely to have to carry it through a period of economic slowdown. As you might expect, the opposite is true of large-caps. They’re generally thought of as more stable and less volatile, though there’s no guarantee.

Technology companies and the funds that invest in them may be exceptions. They can be some of the biggest companies in the world, measured by market capitalization. But their prices still tend to be extremely volatile. So a large-cap fund with major investments in technology companies might behave more like a small-cap fund than a large-cap fund investing in blue chip companies.

stock-fund

How do stock funds diversify portfolio?

Many stock fund portfolios include 100 or more companies whose products and services span many different parts of the economy. For example, a typical fund might own stock in companies whose businesses are as varied as electronics, automobiles, retail clothing, financial services, software, pharmaceuticals, energy, technology, and telecommunications. In fact, diversified portfolios of this kind are one of the defining features of mutual funds. And investors consider diversification one of funds’ greatest appeals.

Another breed, called sector funds, invests only in the stocks of a particular segment of the economy or in a particular industry, such as energy or healthcare. While a sector fund is more diversified than a single stock, since it might own dozens of stocks in its area of interest, there’s nothing in the fund’s portfolio that could offset a downturn in the sector it invests in.

Stock funds are subject to market risk, and their principal value and investment return will fluctuate in response to changing market conditions.

Since any sector can be highly volatile, these funds provide an opportunity for big profits if you’re invested at the right time. But there is always the equal and opposite risk that one year’s strong sector may provide weak returns the next.

Sector funds may work well in a core and satellite strategy, though. You put most of your money in broadly diversified equity funds — the core — and the rest in a revolving group of satellite sector funds.

Why Stock Funds Are Widely Offered For 401k? by Inna Rosputnia

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