Benefits and Drawbacks of Mutual Funds
By: Source: AARP.org Date Posted: 2005-03-20 12:08:23
Like almost anything, mutual funds have their good points and their bad points. On the plus side, mutual funds are diversified and professionally managed. But they also carry fees, costs, and tax obligations. Familiarize yourself with the benefits and drawbacks of mutual funds and then decide if these funds are for you.
What You Should Know
Benefits of Mutual Funds
Mutual funds are a popular investment tool, for a variety of reasons:
- Diversification. The best mutual funds design their portfolios so individual investments will react differently to the same economic conditions. For example, economic conditions like a rise in interest rates may cause certain securities in a diversified portfolio to decrease in value. Other securities in the portfolio will respond to the same economic conditions by increasing in value. When a portfolio is balanced in this way, the value of the overall portfolio should gradually increase over time, even if some securities lose value.
- Professional management. Most mutual funds pay topflight professionals to manage their investments. These managers decide what securities the fund will buy and sell.
- Regulatory oversight. Mutual funds are subject to many government regulations that protect investors from fraud.
- Liquidity. It's easy to get your money out of a mutual fund. Write a check, make a call, and you've got the cash.
- Convenience. You can usually buy mutual fund shares by mail, phone, or over the Internet.
- Low cost. Mutual fund expenses are often no more than 1.5 percent of your investment. Expenses for Index Funds are less than that, because index funds are not actively managed. Instead, they automatically buy stock in companies that are listed on a specific index.
Drawbacks of Mutual Funds
Mutual funds have their drawbacks and may not be for everyone:
- No Guarantees. No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a mutual fund runs the risk of losing money.
- Fees and commissions. All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund.
- Taxes. During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you receive, even if you reinvest the money you made.
- Management risk. When you invest in a mutual fund, you depend on the fund's manager to make the right decisions regarding the fund's portfolio. If the manager does not perform as well as you had hoped, you might not make as much money on your investment as you expected. Of course, if you invest in Index Funds, you forego management risk, because these funds do not employ managers.
For More Information
The Alliance for Investor Education
You can test your knowledge about mutual funds on a Web site run by the Alliance for Investor Education. The site also features a mutual fund fee calculator and a "Guide to Understanding Mutual Funds."
URL: http://www.investoreducation.org
The Securities and Exchange Commission (SEC)
The SEC Web site offers a variety of useful information for investors. Under "Investor Education," look for online publications about mutual funds and Interactive Tools, including a Mutual Fund Cost Calculator that will help you compare the true dollar cost of mutual funds. Use the EDGAR Database (listed under "SEC Filings and Forms") to find and read a mutual fund's prospectus.
URL: http://www.sec.gov
The Investment Company Institute (ICI)
ICI is a trade organization for the mutual fund industry. The group publishes a host of information about mutual funds, including: "A Guide to Understanding Mutual Funds" and "Mutual Fund Fact Book."
URL: http://www.ici.org
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