If you've heard of mutual funds but are not exactly sure what they are or how they work, you are not alone. These investment options can help diversify portfolios, but they come with their own advantages and potential drawbacks.
Gaining a basic understanding of mutual funds can help you decide whether they may support your goals. Here is an introduction to what you need to know about these investments, along with an overview of common pros and cons.
What Are Mutual Funds?
Mutual funds are pooled investments that may include dozens or hundreds of securities, such as stocks or bonds, packaged into one investment. Mutual funds may be actively managed, where a fund manager or management team selects the securities in the portfolio. They may also be passively managed, which means they track the performance of a benchmark index.
There are many types of mutual funds. They are usually grouped by their objectives, such as growth or income, by market capitalization, such as large-cap, mid-cap, or small-cap stocks, or by sector, such as technology or healthcare. Mutual funds may also invest in bonds, which are often grouped by maturity, such as short-term, intermediate-term, and long-term, and by issuer, such as corporations, municipalities, or the government.
You can buy mutual funds in a way that is similar to buying shares of a single stock. The key difference is that mutual funds include a mix of stocks and bonds within one investment.
What Are the Pros & Cons of Mutual Funds?
There are several mutual fund advantages and potential drawbacks that investors should be aware of before deciding to invest. While mutual funds offer benefits such as convenience, diversification, professional management and compound interest, they also can have high fees, market risk, manager risk and tax inefficiency. Before you get involved, weigh these points against your personal financial goals:
Possible Pros
- Convenience: Investors can choose a mutual fund that includes many investments within one packaged option.
- Diversification: Mutual funds often invest in a wide range of stocks or bonds, which provides built-in diversification. This can help reduce market risk in a portfolio. Diversification does not guarantee profit or prevent losses in a declining market.1
- Professional Management: Instead of researching and selecting individual investments, investors can rely on a professional to manage the fund’s portfolio.
- Compound Growth: Investors can reinvest dividends and interest to buy more shares. Over time, this can increase growth as earnings build on previous earnings.
Potential Cons
- Fees: Mutual funds have expenses, often ranging from 0.50% to 1%, to cover management and operating costs. Some funds also include sales charges, known as loads, when buying or selling shares.
- Market Risk: Like stocks and bonds, mutual funds can rise or fall in value. There is also principal risk, meaning you could lose your original investment. Investments can lose value over time, and past results do not predict future performance.
- Manager Risk: With actively managed funds, performance depends on the decisions of the portfolio manager. Poor timing or judgment can affect returns.
- Tax Considerations: Mutual funds may distribute capital gains when securities are sold within the fund. Investors may owe taxes on these gains, as well as on dividends and interest, even if they did not sell shares.
The Bottom Line
Mutual funds offer several advantages, including convenience, diversification, and professional management. However, they may not be the right fit for every investor. Understanding both the benefits and the drawbacks can help you decide if they align with your goals. As with any major decision, consider speaking with a financial professional to review your options.
Footnotes
- Diversification does not ensure a profit or protect against a loss in declining markets.
