Investing can be intimidating for beginners. One of the most popular ways to invest is through mutual funds. Mutual funds give an investor access to a group of stocks or other securities without requiring large amounts of capital and at relatively low risk. However, there are some concerns about whether these popular investment vehicles are safe.
Mutual fund pools the investments of many different investors
A mutual fund pools the investments of many different investors into one fund that invests in multiple types of securities like stocks, bonds, foreign currencies, precious metals and more (Mutual Funds). The portfolio manager then takes those pooled investments and selects which securities will make up the current holdings; this process requires research on the part of the mutual fund company (Mutual Funds). It gives more accessible access to professional managers since the research is already done but can also expose an investor to many risks.
One important risk factor for a mutual fund is its expense ratio (Mutual Funds). Expense ratios are fees that mutual funds charge investors as a percentage of the fund’s assets every year; this fee covers operating costs and management expenses incurred by the fund company (Mutual Funds).
Mutual funds with high expense ratios indicate greater risk because they require additional overhead to run, which may come at the cost of their performance or cut into returns to investors. An example from 2009 shows just how badly higher fees can hurt even a solid performer: The Vanguard 500 Index Fund had an average annual return of 14% per year, while the average yearly return for the fund with the highest expense ratio was just 9.5% (Mutual Funds). This loss is significant given that over ten years, high fees added up to be more than $60,000 in lost earnings (Mutual Funds)
Another risk of investing in mutual funds is market risk, which means the potential for individual investments to lose value if their sector or industry performs poorly. One example showing how this can affect investors comes from 2008 during the financial crisis.
At that time, many banks were affected by credit downgrades, and some went out of business entirely; one of these was Lehman Brothers, whose stock price dropped substantially when it declared bankruptcy (Lehman Brothers Bankruptcy Announcement). This price drop also affected investors with mutual funds that contained Lehman Brothers’ stock, including the T. Rowe Price New Horizons Fund (Lehman Brothers Bankruptcy Announcement).
Specific country risk
Other types of risk for shareholders include specific country risk, which means the possibility of loss due to factors outside of an individual investment’s value. The most common example is currency rates; if an investor has $10,000 worth of British Pound Sterling and loses 10% of its value relative to the U.S. dollar, their holdings are now only worth $9,000 (British Pound Sterling).
Mutual funds can help protect against specific country risks by offering diversification across multiple countries. This protection is less adequate when investing in other markets like emerging and frontier markets, which carry more market and specific country risk than developed countries (Berube).
There is also reinvestment risk, which refers to the effects of dividend distributions and price changes on an investor’s holdings. For example, suppose a mutual fund’s stock prices decline by 5% in one day but are expected to make up for it with high dividends or other gains over the next few weeks. In that case, an investor should consider waiting until this happens before making any moves (Mutual Funds).
However, many investors seek profits without considering these expectations; if they sell their shares after seeing their value drop, they miss out on potential gains that would have made up for the initial loss (Mutual Funds).
Read more about mutual funds here.