Although mutual funds are tremendously varied, flexible, and convenient, they have disadvantages that you need to consider before investing.Risks involving fund management
These days, mutual funds are among your safer investment options. Diversification, professional management, and the fraud-prevention exercised by the Security Exchange Commission and other regulatory bodies all help ensure that mutual funds stay relatively safe. Nonetheless, investing in mutual funds carries various kinds of risk that can impact your financial planning. One risk that’s inherent in the nature of mutual funds is the fact that you, the investor, have no control over what’s being purchased for the portfolio. You are putting your money — and your investment fate — in the hands of the fund manager, which is why you need to study the track record of the fund company and the individual manager before you invest.
Risk involving changes in the market
Even with expert management, however, the risk involved in mutual fund investing does not disappear. Sometimes, the stock or bond market as a whole may be in decline, and even smart investors are unable to make a profit. Such hard times
are referred to as ear markets.The opposite of a bear market is a time when the markets are steadily rising — bull market. Pessimistic investors are sometimes
referred to as bears, while optimists are bulls. Now you understand the livestock references that you often hear scattered throughout financial news reports!
If you’re a long-term investor, bear markets may not be a problem. You can probably wait until the market reboundsbefore selling your shares. A short-term investor, however,may get stuck with losses. Although you can’t avoid risk altogether,
you can choose money market mutual funds or other investments that don’t tend to fluctuate dramatically,Unclear investment approach Sometimes funds are managed in ways that contradict the image presented in advertising or promotion. A fund that is
touted as a conservative fund — one that selects investments so as to minimize risk and volatility — may be managed in an aggressive manner, putting money into highly volatile small-company stocks.
Lack of insurance for fund investments
Unlike your deposit in a bank, credit union, or savings and loan association (S&L), your investment in a mutual fund is not insured by the Federal Deposit Insurance Corporation or any other government agency. (Supervision of investmentcompanies by the Security Exchange Commission and other organizations does not insure the value of your investment.)Therefore, when the fund invests in securities that rise and
fall in value, you have the possibility of losing your initial investment.
Tax inefficiency
Another disadvantage to mutual funds is that stock funds (also called equity funds) are not very “tax-efficient.” Here’s how this inefficiency plays out in your overall investment picture:When you own individual stocks, you decide when to buy and sell them.
When you sell a stock that has increased in price, you receive a type of profit known as a capital gain. At the end of the year,you must pay taxes to the IRS on all the capital gains you enjoyed during that year. But with mutual funds, the schedule of stock purchases and sales is up to the fund manager —you don’t have control of the timing.
Uncertainty about redemption price
When you own an individual stock, you can choose to sell it at any time during the trading day (that is, while the stock market is in operation), and you will get the price that’s current at the moment you sell. When the stock market, or a particular stock, is very volatile, your selling price can change significantly throughout the day.
No maturity dates
Another disadvantage of mutual funds relates specifically to bond funds — that is, funds that specialize in bonds rather than stocks or other investments. Typically, when you invest in an individual bond, you are given a maturity date — that is, the date when the loan represented by the bond comes due. On that date, you get back the amount you paid for the bond (the principal), plus interest. The return is certain,unless the company or the government body that issued the bond runs into financial difficulties.