Advantages of Mutual Funds

Mutual funds have become popular because they offer 4 advantages:

• Diversification. A single mutual fund can hold securities from hundreds or even thousands of issuers, far more than most investors could afford on their own. This diversification sharply reduces the risk of a serious loss due to problems in a particular company or industry.

• Professional management. Few investors have the time or expertise to manage their personal investments every day, to efficiently reinvest interest or dividend income, or to investigate the thousands of securities available in the financial markets. They prefer to rely on a mutual fund's investment adviser. With access to extensive research, market information, and skilled securities traders, the adviser decides which securities to buy and sell for the fund.

• Liquidity. Shares in a mutual fund can be bought and sold any business day, so investors have easy access to their money. While many individual securities can also be bought and sold readily, others aren't widely traded. In those situations, it could take several days or even longer to build or sell a position.

• Convenience. Mutual funds offer services that make investing easier. Fund shares can be bought or sold by mail, telephone, or the Internet, so you can easily move your money from one fund to another as your financial needs change. You can even schedule automatic investments into a fund from your bank account, or you can arrange automatic transfers from a fund to your bank account to meet expenses. Most major fund companies offer extensive recordkeeping services to help you track your transactions, complete your tax returns, and follow your funds' performance.

 Caveats of Mutual Funds

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.
• 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.