Many investors use mutual funds to capitalize on diversification and professional management and to save for retirement. A mutual fund collects money from different investors and purchases a variety of assets with the collective money. As with most investments, mutual funds carry risks and rewards. Before investing in a mutual fund, understand how its risks measure up against rewards.
Defining Mutual Fund Risk
Mutual fund risk is the possibility of losing your money if the investment fails. Unlike some other types of investments, mutual funds are not insured by the Federal Deposit Insurance Corporation. Mutual fund risks vary depending on the type of fund. For example, money market mutual funds are less risky than stock mutual funds. Generally, a fund carrying more risk has the potential to generate higher returns. Riskier funds are more volatile and you risk large losses investing in them.
Risks to Consider
The risks associated with a mutual fund are largely determined by its underlying assets. For example, risks related to bond funds include interest rate, call and credit risks. Interest rate risk relates to the possibility that the bond declines in value if interest rates rise. Call risk relates to the possibility that the issuer redeems the bond before maturity because of declining interest rates. Credit risk is the possibility that the issuer defaults on its obligation to pay investors. Other risks related to mutual funds include income, manager, inflation, market and principal risks.
The primary reward of a mutual fund is the potential to earn returns on your investment. You can generate income from mutual fund investing in several ways. Depending on the type of mutual fund you own, you can earn interest or dividend payments from your investments. If the fund manager sells shares within your fund for a profit, you can earn a capital gain. You can also earn a return on your investment by selling shares within the mutual fund.
Other rewards of mutual fund investing include the management of your assets by an investment adviser registered with the Securities and Exchange Commission. Fund managers perform all of the necessary investment research and continually monitor how the securities perform. Diversification is another primary reward of mutual fund investing. Diversifying your assets allows you to spread risk over a variety of securities, allowing you to decrease the chance of losing money. Small investors benefit from mutual fund investing. The minimum investment in a mutual fund is cheaper than buying the same assets individually.
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