Understanding Mutual Funds: Are They Safe?

banking and finance

What is a Mutual Fund

There are different assets and holdings to invest with higher and lower risks in the financial market. A mutual fund works as a company that pools money collected within a diverse set of investors. This money is invested in a varied set of securities, or financial products, such as bonds. The whole set of holdings is known as a portfolio. The management of the funds is carried out by money managers who find the right allocation, optimizing and monitoring the capital gains for the investors.

This limits the decision power of its investors. Indeed, holders do not have voting rights. As a matter of fact, the ownership of the fund is represented by the shares. The gains and losses will then be distributed proportionally among the shareholders. Mutual funds are attractive to conservative risk profiles, as they are affordable, diversified, and allows the investors to easily redeem any fees.

Types of Mutual Funds 

Depending on the nature of the securities included in each fund, the mutual funds can be categorized into different types.

Some of the most common funds are denominated money market funds. This type of fund has a lower risk and is made through short-term instruments. The safety of the fund responds to the type of investment, which is made only through safe assets.

As aforementioned, the risk profiles respond to different types of mutual funds. To more aggressive risk profiles, bond funds address the investment through bonds. Stock funds, conversely, allocate the investment using corporate stocks of a diverse nature (regular dividends stocks, non-regular ones, index funds, or specialized sector funds of a specific industry). Finally, target-date funds manage the investment with a varied set of financial assets, shifting the mix periodically.

Risks Management

Any type of investment has an inherent risk associated with it, which varies according to the sector and types of assets used to invest. The nature of the mutual funds makes them very suitable for risk-averse profiles. Mutual funds reduce the risk through three axes: volatility, concentration, and inflation control procedures. For the former item, a systematic investment plan (small investments in short time intervals), such as those applied in a mutual fund, reduces the risks derived from the market variability.

Following with the next one, i.e. concentration, the famous financial advice gives us a clear hint on the strategy used: “One should not put all the eggs in the same basket”. As mutual funds are defined mostly as a vehicle of investment in varied sectors using different assets, the impact on diversified portfolios allows investors to foresee and prevent dramatic loss. Lastly, the funds also have advantages in terms of taxation, such as tax savings and a paying free-tax scheme for the returns.

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