Risks & Benefits of Mutual Funds

by Rose Johnson

Many people saving for retirement or looking for diversification choose mutual funds as investment options. Investing in mutual funds provides clear benefits and offers some risks. It is important for investors to understand the advantages and disadvantages of investing in mutual funds before making an investment decision. The importance of mutual funds' risks and rewards depend on your individual financial goals and risk tolerance.

Asset Allocation

When you invest in a mutual fund, you are actually investing in every asset the mutual fund holds. A mutual fund may invest in stocks, bonds, cash or real estate investment trusts. This variety of asset allocation benefits investors because can help shield investors from company- or sector-specific risks. Most mutual funds hold assets that do not flow in the same direction. For example, if interest rates rise, the value of your bonds may fall but the value of your stocks may increase within your mutual fund. Also, mutual funds typically offer asset allocation options that meet your personal investing preference. For example, if you are nearing retirement, mutual funds exist that invest mainly in bonds and lower-risk stocks.

Professional Management

A professional portfolio manager buys and sells assets in an actively managed mutual fund. Investors without the financial expertise or time needed to research assets find this feature advantageous. Professional investment managers spend their time thoroughly researching potential investments and making investment decisions in the best interest of investors. A mutual fund collects money from different investors, so the cost to obtain professional research is lower than it cost to hire an investment analyst on your own. Mutual fund managers can obtain access to research resources that an average small investor cannot obtain. Therefore, investing in a portfolio with a proven fund manager provides many benefits.

Market and Price Risks

Despite diversification, mutual funds are still at risk to events occurring in the financial markets. If the financial markets suffer for an extended period of time, your mutual fund may experience negative returns. Some mutual funds eventually recover from losses, while others fail to recover. Investors are exposed to price risk through mutual fund investments. The price of a mutual fund is calculated once a day, so it is impossible to gain real-time values throughout the day. When you decide to buy or sell a mutual fund, the price you are quoted may differ from the purchase or sale price once the fund manager calculates the net asset value (NAV) at the close of the day.

Cost and Fees

Even when a mutual fund performs poorly, you must still pay the fees associated with the fund. Although fees vary, some mutual funds are relatively expensive. According to the Securities and Exchange Commission, common mutual fund fees include portfolio management fees, shareholder fees, transaction fees, redemption fees, account fees and operating expenses. Fees can drastically reduce the returns of small investors, so it is important to understand the risk of fees to your portfolio's total return.

Index Funds

Index funds are a type of mutual fund that follows a particular index, such as the S&P; 500 or the Russell 2000. An index fund holds all of the assets of a particular index to replicate the changes in the index. An advantage of investing in an index fund is lower fees and expenses than an actively managed mutual fund. This is because index funds are passively managed. Another advantage of investing in an index fund is that it's more tax favorable than an actively managed mutual fund. Index funds do not make trades or realize capital gains as often as actively managed funds, and therefore investors pay less in capital gains taxes. The disadvantage of investing in an index fund is that you cannot outperform the market because the sole purpose of an index fund is to reflect the movement of an index.

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