How mutual funds work

Your employer’s 401(k) offers you the opportunity to invest in the financial markets through investment vehicles known as mutual funds. (Your plan might also offer other investment options; ask your plan administrator or Human Resources representative.)

A mutual fund acts as an investment company that pools the money of many shareholders and invests that money in stocks, bonds, money market instruments and other securities. Americans have more than $12 trillion dollars invested in mutual funds that buy stocks, bonds, money market instruments and other securities,* with much of that money coming from retirement plans such as yours.

Mutual funds have become so popular because they offer some outstanding potential benefits:

  • Funds are run by experienced, professional money investment managers, who constantly pay close attention to the financial markets and make informed decisions on your behalf.
  • Most funds own dozens or hundreds of stocks or bonds, often in various sectors. With a single investment, you could achieve the kind of broad diversification we discussed earlier.
  • Although no investment approach can guarantee that it will protect your account from risk, investing in widely funds could help reduce volatility in a single stock or industry.
  • Your 401(k) offers you a variety of quality mutual funds, so you can choose the ones that best meet your particular investment needs.
  • Funds periodically distribute income and capital gains (profits in assets that rise in value). Your funds will automatically reinvest these distributions for you, increasing the number of shares you own.

Mutual funds, such as the ones offered in your company plan, make it possible for you to invest in many different securities with a relatively modest amount of money, and enable you to accumulate assets for retirement.

*As of November 30, 2007. Source: Investment Company Institute.

Understanding risk

While mutual funds and other investments certainly provide potential growth opportunities, investing comes with a number of risks, such as:

Company risk, the risk that an individual stock will decline in value. (Investing in mutual funds can reduce company risk, since a fund generally will own many stocks.)

Market risk, the risk that the market as a whole will fall.

Interest-rate risk, the risk that rising interest rates will reduce the value of bonds. (Bond prices decline when interest rates rise.)

Credit risk, the risk that a company’s or government’s credit rating is cut, thus lowering the value of bonds issued by that company or government. (Diversification can moderate credit risk.)

Inflation risk, the risk that rising prices will reduce the purchasing power of your savings, especially during retirement. (Investing in securities with long-term growth potential could help your portfolio stay ahead of inflation.)

Yes, risk is part of investing in the financial markets. Still, experienced investors know that risk shouldn’t be feared, but understood and managed.

Because the greatest risk of all is to wait – to delay taking advantage of opportunities, such as the mutual funds provided by your employer’s plan, that could help you save for a comfortable retirement.

Risk Tolerance Questionnaire

The questionnaire linked here can help you determine how to allocate your retirement plan contributions among different investments. There are no "right" or "wrong" answers, only responses that reflect your situation. Your "score" will provide a starting point for allocating your contributions (as well as your existing balances) among available investment options.

Go to the interactive Risk Tolerance Questionnaire