A mutual fund provides an opportunity for long-term growth and supplemental income. As with any type of investment, a mutual fund exposes you to a degree of risk. Unlike bank-insured deposits, those in mutual funds are protected. In theory, you could lose your entire investment if a mutual fund performs poorly. However, while losses are not uncommon, there are many aspects to a mutual fund that work to minimize the risk of a total loss.
A mutual fund is formed when an investment company creates a portfolio of investments. Every fund has a stated strategy or goal, and the securities held within the fund reflect the fund's long-term objectives. A growth fund typically contains stocks, while an income fund holds interest-generating instruments, such as bonds or mortgage-backed securities. Mutual funds are priced daily after the close of the stock market. The fund's daily value is based upon the market value of the securities it owns. The price per share is calculated by dividing the value of the fund's holdings among the shares. If you redeem your shares, you receive a sum of money that equals the net asset value of your shares.
A share of stock represents an ownership stake in a company. If a company goes bankrupt, its stock typically becomes worthless. Bonds, however, are loans, and when you buy one of these instruments you run the risk that the borrower will default on the debt. If this happens, your income dries up but you do not necessarily lose everything. It may take time, but debt instruments often have some residual value as creditors have the right to place claims on the issuer's assets after a bankruptcy. You might not get back your entire investment, but you may get some cash back. With mutual funds, shares in a bond heavy fund may plummet after a default but recover some value in the long term.
Diversity offers you a degree of protection from mutual fund losses. When you buy shares in a fund that invests only in certain types of corporations, you may lose everything if technological advances or economic factors cause those industries to run into financial problems. If you buy shares in a fund that invests in many different industries, your shares will only become worthless if all the companies from all the different industries go bankrupt. You further safeguard your investment if you buy shares in a mutual fund that also holds other kinds of securities, such as bonds, real estate assets and even cash.
Many mutual funds are actively managed, which means fund operators constantly buy and sell securities. The intention of these trades is to make money by selling assets when existing holdings rise in value and to take advantage of price drops to buy other securities at a discount. With an actively traded ufnd, you are unlikely to have a situation in which all of the fund's money is currently tied up in securities. While there is some cash in the fund, the fund's value cannot drop to zero even if all of the other holdings become worthless. Many mutual fund companies require fund managers to always keep a certain amount of the fund's holdings in cash to safeguard against losses.
Aside from performance losses, you could lose money in a mutual fund if the investment firm holding your shares goes bankrupt. However, most brokerage firms belong to the Securities and Investor Protection Corporation. This nonprofit, member-owned organization was created in 1970 to safeguard investors. The SIPC insures investment holdings -- including shares -- up to $500,000 per account holder per investment company. The SIPC does not compensate you if your mutual fund drops in value due to performance issues, but it does compensate you if lose your money because your broker becomes insolvent.
Video of the Day
- Duncan Smith/Photodisc/Getty Images