When you invest in a mutual fund, you benefit from:
Funds invest in an array of securities -from just a handful to thousands of separate issues, depending on the fund's investment objective. This broad exposure helps reduce -although it doesn't eliminate -your risk of loss from problems with a single issuer.
An experienced manager makes sure the fund's investments remain consistent with its investment objective-whether that's to track a market index or use extensive research and market forecasts to actively select securities.
Liquidity. You can sell mutual fund shares whenever you want. It's easy, and there is no penalty for early withdrawal (although there may be a redemption fee, depending on the fund).
With most mutual funds, you can buy and sell shares, change distribution options, and obtain information by telephone, by mail, or online.
But mutual funds have disadvantages too. Those include:
Your stock or bond fund investment, unlike a bank deposit, could fall in value. And, while a money market fund seeks a stable share price, its yield fluctuates, unlike a certificate of deposit. In addition, mutual funds are not insured or guaranteed by an agency of the U.S. government.
The Diversification "Penalty."
Diversification can help to eliminate your risk of loss from holding a single security, but it limits your potential for a "big score" if a single security increases dramatically in value. Remember, too, that diversification does not protect you from an overall decline in the market.
Potentially High Costs.
Mutual funds can be a cost-effective way to buy a variety of securities. But in some cases, the efficiencies of fund ownership are offset by a combination of steep sales commissions, 12b-1 fees, redemption fees, and high operating expenses. It's important to compare the costs of funds you are considering.
Defining Mutual Fund Risks
Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. At the heart of investing is the "risk/return trade-off"-the tendency for potential risk to vary directly with potential return. The more risk you take, the greater your potential return, and vice versa.
Of the three asset classes, cash investments, which offer the greatest price stability, have yielded the lowest long-term returns. Bonds experience more short-term price swings, and in turn have generated higher long-term returns. Stocks historically have been subject to the greatest short-term price fluctuations-and have provided the highest long-term returns.
Mutual funds face risks based on the asset classes of the investments they hold. For example, a bond fund faces the risk that its income will decline due to falling market interest rates (income risk)-a risk of much less concern with a stock fund.
Funds also face risks based on the types of investments they hold within an asset class. For example, income risk is greater for a short-term bond fund than for a long-term bond fund. Similarly, a sector stock fund (which invests in a single industry, such as telecommunications) is at risk that its price will decline due to developments in its industry. A stock fund that invests across many industries is sheltered from this risk (industry risk).
Following is a glossary of some risks to consider when investing in mutual funds.
The possibility that falling interest rates will cause a bond issuer to redeem -or call -its high-yielding bond before the bond's maturity date.
The possibility that political events (a war, national elections), financial problems (rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country's economy and cause investments in that country to decline.
The possibility that a bond issuer will fail to repay interest and principal in a timely manner. Also called default risk.
The possibility that returns could be reduced for Americans investing in foreign securities because of a rise in the value of the U.S. dollar against foreign currencies. Also called exchange-rate risk.
The possibility that a fixed-income fund's dividends will decline as a result of falling overall interest rates.
The possibility that a group of stocks in a single industry will decline in price due to developments in that industry.
Inflation Risk. The possibility that increases in the cost of living will reduce or eliminate a fund's real inflation-adjusted returns.
Interest Rate Risk.
The possibility that a bond fund will decline in value because of an increase in interest rates.
The possibility that an actively managed stock or bond fund's investment adviser will fail to execute the fund's investment strategy effectively and, as a result, the fund will fail to achieve its stated objective.
The possibility that stock fund or bond fund prices overall will decline over short or even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods when prices fall.
The possibility that an investment will go down in value, or "lose money."