When you express interest in buying shares of a mutual fund, the fund company sends you a prospectus. This document explains what the mutual fund invests in. This prospectus also includes a disclaimer notifying you that your investment can lose value. While mutual funds offer the protection of investing in many stocks, that protection could fail in the event of a bad market or if many investors decided to sell the fund at the same time.
A failure of a fund occurs when the fund runs out of money. For example, if some bad economic news persuaded all investors in a mutual fund to sell their shares and get out, the fund would lose value. This is called a "run," and desperate sellers could drive the prices down to zero. When there are more sellers than buyers, the share price drops because buyers will wait while sellers underbid each other.
Mutual funds carry insurance with the Securities Investor Protection Corporation. This insurance guarantees the money to investors who want to redeem their shares in a fund. However, this does not protect your original investment. The SPIC guarantees you full payment for your shares when you decide to sell. For example, if you bought shares for $25 and the price dropped to $5, you might decide to sell. The SPIC would guarantee you get your $5 per share, not your original investment of $25 per share.
Your share of a mutual fund has a value at the end of each stock market trading day. The fund sets that value based on the value of all of the stocks it owns and how they performed that day. If the stocks went up, the value of a share of the mutual fund goes up. If stocks declined, the mutual fund shares will decline in price. If you bought ABC Mutual Fund for $25 per share and the stocks in that fund dropped the next day, the fund might list its share price at $24. That means if you sold your shares the next day, you would lose $1 per share.
A mutual fund going down in price does not automatically mean it failed. In fact, you should expect share prices of a fund to fluctuate. If you bought shares for $25 each and the price dropped to $20, you would have a large loss if you sold. However, if you decided to keep your shares and they subsequently go up to $30 per share, you would have a profit. The drop to $20 did not constitute a failure of the fund.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.