Mutual funds are a type of collectively-managed investment. Money from several investors is pooled together and then put into stocks, bonds, or other securities. There are several benefits to buying mutual funds, such as diversification and ready liquidity. However, like any stock, mutual funds also come with some risks.
With mutual funds, there is a risk that the issuers may fail to pay off the interest and principal on time. This is more of an issue with bonds than other kinds of mutual funds, but usually not an issue with U.S. treasury bonds.
With bonds, there is always the risk that the issuer will recall the bond before the date of maturity, usually due to falling interest rates. This is called call risk.
Always possible with mutual funds is principal risk, the risk that the investment will go down in value and lose money from the original amount invested.
This is the risk that a bond will pay off earlier than expected. When interest rates fall, there is a chance that the issuer of the bond will decide to cut losses and retire its debt via old bonds, then reissue new bonds at a lower rate of payout.
According to the United States Securities and Exchange Commission, market risk, the rising and falling of the value of stocks, “poses the greatest potential danger in stocks funds.” Market risks do tend to move in cycles, but these cycles can be over both long and short periods of time, and are always unpredictable.
Country risk is when political, natural or economic events in a country influence the value of investments in that country. For example, investments in a country suddenly struck by a hurricane would more than likely result in a subsequent large loss in investment value.
Inflation risk happens when increases in the cost of living make the yields from mutual fund investments worth much less, adjusted against inflation, than they would have been otherwise.
One of the benefits of mutual funds is the opportunity to have your investments professionally managed, However, this can turn into a distinct disadvantage if the manager fails to perform his duties effectively.
This risk, also called exchange rate risk, generally applies only to investments in foreign securities. Currency risk is when the rising or falling value of the dollar against foreign currency results in a reduction in returns for investors.