As with any investment, mutual funds come with some caveats, and you should understand those before you invest.
In the sections below, we describe these risks in more detail.
Mutual funds are regulated by the U.S. Securities and Exchange Commission (SEC), which requires funds to disclose the information an investor needs to make sound decisions. Unlike bank deposits, mutual fund shares are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other agency of the U.S. government. In fact, the value of a mutual fund may fluctuate, even if the fund invests in U.S. government securities.
While diversification eliminates the risk of catastrophic loss that would occur if you own a single security whose value plummets, it also limits the potential for making a killing in the market if that security’s value shoots up. It’s important to note that diversification does not protect you from a loss caused by an overall decline in financial markets.
Mutual funds can be a lower-cost way to invest when compared with buying individual securities through a broker. However, a combination of sales commissions and high operating expenses at some fund companies will reduce your investment returns. Compare the costs of mutual funds. High costs can badly damage the returns you receive as a shareholder.
The profits on a mutual fund investment are typically subject to federal (and often, state and local) income tax unless you’re investing through a tax-free retirement or education account. If you invest in a regular taxable account, then dividend and taxable interest distributions you receive are taxed as ordinary income each year. A mutual fund also is required to distribute its net realized capital gains each year, and those distributions are taxed as either short-term gains (the same tax rate as ordinary income) or long-term gains (taxed at a lower rate), depending on how long the fund held the securities.
A fund that buys and sells securities frequently may add to your tax bill with hefty capital gains distributions. You would also incur taxes on your capital gains-and pay taxes at short-or long-term rates depending on how long you had held the shares-if you redeem shares in a fund at a price higher than you paid for them.
Later in this Chapter, we describe some techniques for minimizing the tax impact of mutual funds.