Investing Unit 6: Disadvantages



1. If there is a broad market drop, your fund’s value will dip with it. The diversification of most mutual funds protects you when one or several securities fall, but not when the whole market takes a downturn. The fact that funds can fluctuate up and down, sometimes wildly, is par for the course and should not deter you from investing or scare you out of the market.

2. There is no guaranteed rate of return with mutual funds as there is with CDs and Treasury securities. Since risk is higher, the liklihood of greater earnings is increased. You must also expect investment performance to fluctuate.

3. Unwanted taxable distributions can also be a disadvantage. Funds are required to pay out 98% of their dividends, interest, and capital gains annually. Taxes must be paid on these distributions, even if you never received them but instead reinvested them in additional shares. Unfortunately, sometimes you can also owe taxes even if your fund lost money for the year. For the time being, however, this is a non-issue, if funds are held in a tax-deferred account such as a 401(k) or IRA.

4. Record-keeping for tax purposes can be hard work. Investors who are not meticulous about keeping track of fund purchases and sales may end up paying higher taxes than are actually owed at the time of sale because of a miscalculation of their cost basis. This is the amount of your original deposit, plus additional contributions and reinvested dividends and capital gains. The amount of taxes you pay will vary depending on the method you use to calculate your gain or loss (e.g., average price, first-in, first-out, or specific identification). Thus, it is important to keep every annual statement for as long as you own the fund.