Funds can be grouped into dozens of possible categories (international, large value, small growth, single country funds, just to name a few). We've chosen to categorize funds according to risk. To streamline the decision-making process, we arrived at four risk classes for equity funds. Bond funds are grouped into a fifth class.

Using broad categories means we have a full range of investment opportunities available to us. For instance, rather than isolating international funds from domestic, we group them with others with similar downside risk. This allows the best to rise to the top, whatever their investment approach might be. There is some overlap; occasionally you may find a Class 2 fund showing no more volatility than a typical Class 3 fund, for example. But overall the classifications provide a realistic indication of what we might expect from a fund.

Occasionally, we reclassify funds when new information indicates a change is in order. Some funds are moving targets, with shifting investment styles. Even funds with consistent styles may experience unexpected volatility during various market cycles.

Our analysis involves assessing a variety of quantitative measures of risk, in addition to questioning portfolio managers, examining investment holdings and surveying independent reporting services.

Class 1: Growth - Most Speculative Stock Funds

Includes funds that focus on special investments such as gold, precious metals or natural resources, specific industries or market sectors. May invest in small, new and unseasoned companies (micro- and Small-Cap). May have very high portfolio turnover. International funds may concentrate in a particular country or region, including "emerging markets" or economies not considered mature. May use investing techniques such as leveraging, margin, short positions or use of derivative instruments such as options or futures in ways likely to increase volatility.
High potential returns concurrent with high possibility of loss.

Class 2: Growth - Speculative Stock Funds

Includes funds invested in small or mid-sized companies. May lack diversification by focusing on a few industry sectors or concentrating portfolio in a few individual holdings. Mostly common stocks, but may contain convertible bonds or other instruments. May have moderate to high portfolio turnover.
High potential returns with higher-than-average volatility or price fluctuation.

Class 3: Growth - Higher Quality Stock Funds
THIS IS OUR RECOMMENDED CLASS

Comprised of diversified portfolios invested in well-established companies. Portfolios may include some fixed-income instruments such as bonds, convertibles, preferred stock or cash. May have flexibility to move to large cash positions. International (foreign) or global (foreign and domestic) funds tend to invest in larger companies in mature economies (e.g., Europe & Japan). Primary objectives are long-term growth with little emphasis on income. With a wide variety of styles represented, the funds do not move in tandem. As a group, they present about the same level of risk as a broad stock market index like the S&P 500 or the Wilshire 5000.

Class 4: Total Return or Balanced Funds

Includes wide variety of investment strategies, usually including common stocks. Often hold income-generating instruments to lower portfolio volatility. These not limited to: corporate or government bonds, convertible bonds, preferred stock, Real Estate Investment Trusts (REITs), repurchase agreements and other money market instruments, or the sale of call options. May focus on high dividend-paying stocks (e.g., utilities companies). May use derivative instruments specifically to lessen volatility, such as futures, put options or short selling. Some portfolios might follow predetermined asset allocations; others may diversify among asset classes at manager's discretion. Primary objectives are moderate long-term growth with income.

Class 5: Income - Bonds, Notes, Money Market Instruments

Primary objective is current income and preservation of capital. This class is divided into three sections:

Corporate: Includes funds invested in corporate debt ranging in credit quality. May include commercial paper, convertible debentures, some money market instruments. Possible limited use of common stocks.

Government: Bonds issued or backed by the U.S. Government or its agencies. Includes U.S. Treasury bonds, notes and bills; debt issued by FNMA (Fannie Mae), FHLMC (Freddie Mac), GNMA (Ginnie Mae); repurchase agreements backed by U.S. Treasury securities.

Municipal: Bonds issued by state or local municipalities. Income is usually exempt from Federal income tax. Income from state bonds is generally exempt from income taxes for that state's residents. Capital gains realized when a fund is sold are taxable.

Bond funds are further segregated by average maturity:

Short-Term: Between 0 and 4 years
Intermediate-Term: Between 4 and 10 years
Long-Term: Between 10 and 25 years
Flexible: Maturities vary at manager discretion.
High-Yield: Focus on bonds of low credit quality. These funds offer higher income yield and potential gain, but increased default risk results in greater volatility.