When people prepare their taxes they are often surprised at the amount of gain that is on their 1099 from the mutual funds that they own. I am often asked, "How can my mutual fund distribute gains in a down market?"
The answer is evident if you look through the mutual fund to the underlying portfolio. The mutual fund portfolio manager will often build up cash heading into downward trending market and may have sold stocks that had accumulated gains over the life of the holding. As the mutual fund manager attempts to accumulate cash in preparation for the down market these gains may be triggered. These gains are accumulated over many years consequently the tax has been deferred for this same period. This is especially the case with value funds that have low turnover ratios.
If you have a net loss in the fund then you can simply sell all of the fund by the end of the year and this negates the gains. If you still have a net gain in the fund then this strategy does not work. But you should consider yourself fortunate if you have a gain.
You should look at your mutual fund as a portfolio rather than just one investment. It provides a convenient way to diversify for the individual making smaller investments. It has economies of scale that you may not get purchasing individual stocks as well as expert management, in most cases. Mutual funds provide the best managers within their respective specialty. This is why I only use mutual funds.
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