Although mutual funds are becoming even more fashionable, you should understand how they are different from other financial intermediaries like banks or insurers.
Mutual funds involve risk
Mutual funds can be risky investments. Although mutual funds are now being sold at banks, under no circumstance is a mutual fund an insured investment like a bank account which enjoys protection from the Federal Deposit Insurance Corporation.
Although most money market mutual funds are arguably as safe or safer than bank accounts, mutual funds don't guarantee that your original investment will be returned to you.
So if mutual funds carry more risk than good old bank accounts, why do people bother to invest in them? The answer is simple : higher potential returns.
Money market funds are good for short-term needs
If you're looking for a good place to keep a few thousand dollars to meet your monthly spending needs, money market mutual funds offer an attractive alternative to bank checking accounts.
Money market mutual funds invest in short-term securities like US Treasury bills and other high-grade, short-term debt. Because mutual funds do not pay insurance premiums to the FDIC, and because mutual funds have lower operating costs than banks, money market mutual funds usually pay higher interest rates than banks, while still providing useful services like check writing privileges.
For more information on money market funds, see my tape on bond and fixed income investing.
Stock & bond funds return more than banks
And if you're looking for a place to invest long-term money, look to the bond and stock funds offered by mutual fund families.
When you invest in a stock or bond mutual fund, you're investing in something which is quite different from slow but steady bank accounts. With a stock or bond mutual fund you easily could see the value of your investment drop 10 or 20 percent over a year. Such a drop won't happen with an insured bank account.
Banks offer safety, but not the potential for higher returns. With a bank account, after a year you'll get your deposit returned to you, along with perhaps 5 percent interest. But in the world of stock and bond mutual funds, you may see that your investment has gained 20 to 30 percent over the year.
Mutual funds as an alternative to insurers
So mutual funds offer a good alternative to traditional bank accounts, but they also provide a good alternative to investing through insurance companies.
Insurance companies manage billions of dollars worth of so-called cash value life insurance. Under this plan the insured pays high monthly premiums to enjoy life insurance coverage plus investment returns from the cash value of the policy.
With the financial turmoil of the late 1970s, investors increasingly turned away from traditional whole life insurance policies and towards much more flexible and low-cost mutual funds for investment purposes.
Types of cash value life insurance
To stem this flow to mutual funds, life insurance companies marketed new forms of cash value life insurance called variable life, universal life, and another product called annuities.
Variable life and universal life are more flexible forms of cash value life insurance. Unfortunately most variable and universal life plans still retain the high premiums, commissions and fees typical of whole life insurance.
Annuities, however, are a kind of retirement account offered by life insurers that have very little to do with insurance. There are two basic forms of annuities, fixed and variable.
Fixed annuities are similar to bond investments and are covered in my tape on bond and fixed income investing.
Variable annuities involve more risk, but offer potentially higher returns. I talk about variable annuities in my tape on stock investing.
Annuities offer some tax advantages that are similar to retirement accounts, but there's a key difference. In most cases, money you put into a retirement account is deductible from your taxable income. Money you put into an annuity is not deductible from your income.
Annuities may have a place in someone's investment totem pole, but they're near the bottom. Consider using an annuity only after you have saved the maximum deductible amount in your retirement accounts.
Copyright 1997 by David Luhman