One way to reduce your investment risk is by spreading it across a number of different securities through a process known as diversification. One of the simplest ways of acquiring a diversified portfolio is by purchasing mutual fund shares. But diversification only reduces risk; it does not eliminate it. In a general down market even diversified portfolios can lose money. In some cases you might need to sell your mutual fund shares even if you have to take a loss.
Pessimism tends to feed on itself, and when investors turn pessimistic, that attitude can result in a self-fulfilling prophesy. As more investors become sellers, there are fewer investors available to buy, and the rules of supply and demand take over. With more shares available and fewer buyers, the market price of stock tends to drop, driving prices even lower. When this trend happens across the board, rather than in just a few select stocks, the economy is said to be in a bear market.
Mutual funds attempt to reduce your risk by investing in a broad range of stocks, based on each fund's particular investment objective. If only one, or even a few, of the stocks in a fund's portfolio decline in value, it's not a big deal. But in a general down market, it is possible for many, or even most, of the stocks to decline, resulting in an overall decline in the mutual fund's net asset value.
Selling Mutual Fund Shares
Mutual fund shares don't trade in the same fashion as stocks. Stock prices can fluctuate constantly throughout the day. Not so with mutual fund shares. The net asset value of mutual funds is determined once per day, after the market closes. You can't enter a sell order on the open market for your mutual fund shares with hopes of selling to the highest bidder. You can only purchase mutual fund shares from the fund itself, and you can only sell your shares back to the fund, although you might have to go through a broker or sales agent to accomplish your buy or sell transaction.
Mutual Fund Redemptions
You mutual fund company must stand ready to redeem its share during regular business hours of each business day, and it must send you a payment for those shares within seven days. The price you receive for your redeemed mutual fund shares will be the net asset value on the day of redemption. Net asset value is determined by dividing the total assets held by the fund by the number of outstanding shares. Some funds might charge a redemption fee, or impose a back-end sales charge on your redeemed shares.
In a down market it is possible that you might sell your mutual fund shares for less than you paid for them. This will result in a capital loss that you can use to offset your other taxable capital gains. If your losses exceed your gains, you might be able to offset some of your other income, including your ordinary income, when you file your federal income tax return.
Video of the Day
- U.S. Securities and Exchange Commission: Mutual Funds
- U.S. Securities and Exchange Commission: Invest Wisely: An Introduction to Mutual Funds
- Fairmark: Selling Mutual Fund Shares
- Investment Company Institute: 2012 Investment Company Fact Book
- U.S. Securities and Exchange Commission: Investment Products: Your Choices
- Fox Business: What Is A Bear Market?
- Dynamic Graphics Group/Dynamic Graphics Group/Getty Images