Mutual funds are a passive investor’s dream. They’re cheap, “diverse,” and (usually) well managed. Compared to a savings account, they seem like a fixed race. And they beat CDs (“certificates of deposit”) by a nose.
But like anything that can seem too good to be true, mutual funds come with their own drawbacks.
Mutual funds pool your money with other investors to buy pre-packaged stocks, bonds, or other securities. These groupings of shares span several companies, hence the reputation as being “diverse” (which, in financial parlance, translates to a “safe” investment). Basically, if Apple stocks plummet but your mutual fund includes IBM, Google, and Verizon shares, your losses won’t be as drastic.
When you’re putting your hard-earned money on the line, it’s important to know what you’re getting into.
- Volatility: Mutual funds are stock market investments, and the stock market is volatile. The higher rate of return comes with the sacrifice of financial security. If the stock market drops, so does the value of your investment.
- Fees: There’s no such thing as a free lunch, as Milton Friedman said. Besides the cost of joining a mutual fund (called a “load”), there are also annual portfolio management fees. If the stock market does fall, you’re still on the hook for those fees. If the market dropped 25 percent, for example, you could have to realize a 33 percent gain just to break even!
- Taxes on Losses: If you buy into a mutual fund when the market is strong, you’ve just invested in stocks that have experienced gains. Those gains are taxable–and they’re taxable even if the mutual fund value falls after you join. In short, the government can tax you for gains you didn’t profit from, just for showing up late to the game.
- Diversification Misconception: Common sense says that diversification equals safety, as the presence of many companies buffers the underperformance of one. This is true, but it’s only half the story. When the stock market crashed in 2008, every major class of asset declined. Tech funds. Health funds. Financials. You name it, investors lost big. That’s because common sense also says that when an industry takes a hit (whether due to regulation, bubbles, natural disaster, or emerging technologies), the mutual funds comprising the companies in those industries also plummet.
Investing in mutual funds depends on your risk tolerance, age, and level of involvement. For those of you nearing retirement, rest assured that there are less dangerous, less volatile options to invest your money.
Contact us today to learn more about what’s right for you.