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Caveats of Investing in Mutual Funds
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As with any investment, mutual funds come with some caveats, and you should
understand those before you invest.
- No guarantees. Mutual funds are regulated by the U.S. Securities
and Exchange Commission (SEC), which requires funds to disclose the
information an investor needs to make sound decisions. Unlike bank
deposits, mutual fund shares are not insured or guaranteed by the Federal
Deposit Insurance Corporation (FDIC) or any other agency of the U.S.
government. In fact, the value of a mutual fund may fluctuate, even if the
fund invests in U.S. government securities.
- Diversification "penalty." While diversification eliminates the
risk of catastrophic loss that would occur if you own a single security
whose value plummets, it also limits the potential for making a killing in
the market if that security's value shoots up. It's important to note that
diversification does not protect you from a loss caused by an overall
decline in financial markets.
- Potentially high costs. Mutual funds can be a lower-cost way to
invest when compared with buying individual securities through a broker.
However, a combination of sales commissions and high operating expenses at
some fund companies will reduce your investment returns. Compare the costs
of mutual funds. High costs can badly damage the returns you receive as a
shareholder. Use Vanguard's Compare
Fund Costs tool to view the effect of mutual fund loads, sales charges,
fees, and other expenses on the returns for Vanguard funds and funds from
other fund families offered through Vanguard's FundAccess program.
YAHOO! FINANCE TIP
Yahoo! Finance reports a mutual fund's cost data on its profile page. For an example, see VFINX's profile page.
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- Tax impact. The profits on a mutual fund investment are
typically subject to federal (and often, state and local) income tax unless
you're investing through a tax-free retirement or education account. If you
invest in a regular taxable account, then dividend and taxable interest
distributions you receive are taxed as ordinary income each year. A mutual
fund also is required to distribute its net realized capital gains each
year, and those distributions are taxed as either short-term gains (the
same tax rate as ordinary income) or long-term gains (taxed at a lower
rate), depending on how long the fund held the securities. A fund that buys
and sells securities frequently may add to your tax bill with hefty capital
gains distributions. You would also incur taxes on your capital gains-and
pay taxes at short-or long-term rates depending on how long you had held
the shares-if you redeem shares in a fund at a price higher than you paid
for them.
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