After reading about many advantages of mutual funds, lets talk a little bit about disadvantages. Yes, like many other investments, mutual funds do not guarantee a return. Unlike fixed-income products, such as bonds and Treasury bills, mutual funds experience price fluctuations along with the stocks and other securities that make up the fund.
Another important thing to know is that mutual funds are not guaranteed by the U.S. government, so in the case of dissolution, you won't get anything back. This is especially important for investors in money market funds. Unlike a bank deposit, a mutual fund will not be FDIC insured.
Although diversification is one of the keys to successful investing, many mutual fund investors tend to overdiversify. The idea of diversification is to reduce the risks associated with holding a single security; overdiversification occurs when investors acquire many funds that are highly related and so don't get the risk reducing benefits of diversification. At the other extreme, just because you own mutual funds doesn't mean you are automatically diversified. For example, a fund that invests only in a particular industry or region is still relatively risky. Because if bad times for that industry come, usually all stocks in that industry will do bad. Don't forget, just because a professional is managing a mutual fund, that does not mean that mutual fund will always do well.
Mutual funds provide investors with professional management; however, this comes at a cost. Funds will typically have a range of different fees that reduce the overall payout. In mutual funds the fees are classified into two categories: shareholder fees and annual fund-operating fees.
The shareholder fees, in the forms of loads and redemption fees, are paid directly by shareholders purchasing or selling the funds. You can read more about load and no-load mutual funds here. The annual fund operating fees are charged as an annual percentage - usually ranging from 1-3%. These fees are assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn't make money these fees only magnify losses.
Also, the misleading advertisements of different funds can guide investors down the wrong path. Some funds may be incorrectly labeled as growth funds, while others are classified as small-cap or income. The SEC requires funds to have at least 80% of assets in the particular type of investment implied in their names. The remaining assets are under the discretion solely of the fund manager.
The different categories that qualify for the required 80% of the assets, however, may be vague and wide-ranging. A fund can therefore manipulate prospective investors by using names that are attractive and misleading. Instead of labeling itself a small cap, a fund may be sold under the heading growth fund. Or, the "Congo High-Tech Fund" could be sold with the title "International High-Tech Fund".
Finally, don't forget the taxes! By investing in mutual funds, you will be taxed in three ways – the sale of shares, capital-gains distributions and dividend distributions. Dividend distributions are primarily from the interest and dividends earned. All these must be reported as income on 1040 federal tax form. Capital-gains distributions are gains from the sale of shares held more than a year. These are taxed as capital gains, usually at lower rates than federal income taxes.
Also be aware that not all funds have the same tax efficiency, and tax efficiency will have an impact on your total return. This depends on how often investments are bought and sold during the year and is called a turnover ratio. Some companies report after-tax returns, and information on tax efficiency should be listed in fund's prospectus. So be sure to check this.
Taxes are not really a disadvantage of mutual funds, because gains on other investments are also taxed (with few exceptions), however, low tax efficiency of the fund can really spoil your gains.
Mutual funds are far from perfect, but if you are a novice investor, or just don't want to get into all that "investing stuff", they are probably the best way to go.