Mutual funds are not FDIC insured: Here's why

Mutual funds, like investments in the stock market, are not insured by the Federal Deposit Insurance Corporation (FDIC) because they do not qualify as financial deposits.

The FDIC is an independent, government-established agency formed in 1933 in response to the widespread failure of America's banks in the 1920s and 1930s, which contributed to the Great Depression. The debilitating impact of the financial crisis prompted the government to develop strategies for preventing future economic collapse.

One way to prevent the kind of domino effect of the Great Depression is to isolate economic turmoil in one industry and prevent it from bleeding over into the rest of the economic structure. By monitoring potential threats to banking and thrift institutions, the FDIC seeks to minimize the impact of economic downturn on depositor funds and the rest of the economy. (For related reading, see "The History of the FDIC.")

The primary way the FDIC protects depositors from losing hard-earned dollars in the event of a financial collapse is by insuring deposits known as FDIC insured accounts. As of 2018, the FDIC insures deposits up to $250,000 per depositor, per institution based on account type. If an insured bank becomes insolvent and fails, depositor funds are insured by the FDIC up to this maximum. While banks may fail, the FDIC protects individual Americans from needlessly suffering the same fate.

Though created by Congress, the FDIC does not receive any government funding. Instead, financial institutions pay a premium for deposit insurance, much like an individual pays a premium for homeowners' or auto insurance. In addition, the FDIC invests in government-issued Treasury bonds (T-bonds) that generate regular interest income.

The FDIC only insures deposits, not investments. This means your checking account, savings account and money market deposit accounts are probably insured unless your financial institution has declined FDIC coverage, which is unlikely. The FDIC also insures certificates of deposit (CDs), money orders and cashiers' checks. Business accounts are afforded the same coverage as individual accounts.

Investment vehicles are typically not insured by the FDIC. In addition to mutual funds, this includes investments in stock and bond markets, annuities, life insurance policies and Treasury securities. Even the stocks, bonds or other vehicles that you might have purchased through your bank's investment department are not insured.

There is often some confusion when it comes to money market mutual funds, because money market deposit accounts are FDIC-insured. The difference between these two types of accounts lies in their respective risk levels. While it is technically possible, though unlikely, to lose your original investment in a money market mutual fund, money market deposit accounts generate interest but carry no risk to your deposited funds. (For related reading, see "Money Market Mutual Funds: A Better Savings Account.")

Individual retirement accounts (IRAs) are another common source of confusion. IRA savings can be invested in a number of different ways, some insured by the FDIC and some not. Basically, if a given type of account is FDIC-insured when it includes regular funds, it is also insured when those funds are part of an IRA. IRA funds deposited in a standard savings account or money market deposit account, for example, are insured. Any IRA savings invested in mutual funds or stocks are not.

The goal of the FDIC is to ensure the citizenry is not bankrupted by another financial crisis. When banks failed during the Great Depression, individual depositors were unable to withdraw their funds because the banks did not actually have the cash to back up all their deposits. Poor business practices on the part of the banking industry ended up costing millions of innocent Americans their life savings. Prior to 1933, there was no federal protection in place to prevent the injustice. The aim, therefore, of the U.S. government in creating the FDIC was not to protect Americans from ever losing money, but rather to protect them from losing money through no fault of their own.

Unlike checking or savings accounts, mutual funds and other securities carry a certain amount of risk. While some amount of risk may be necessary for big profits to be made, investors know going in there is a chance they could lose everything. This is why the FDIC does not insure investments.

When all is said and done, investing is basically high-tech gambling. While you expect an insurance company to reimburse you if your insured property is stolen from your home, you do not expect a casino to reimburse you if you lose money at the poker table. All gamblers know the risk of loss as soon as they set foot on the casino floor; the same should be true of investors.

Though there is no entity that insures you against investment loss due to market fluctuation, the Securities Investor Protection Corporation (SIPC) does protect investors from loss if their brokerage firms fail. Customers of SIPC-member institutions who lose money as a result of company liquidation are insured up to $500,000, with a $250,000 cash sub-limit. In addition to mutual fund investments, the SIPC protects investments in stocks, bonds, options, Treasury securities and CDs.

Of course, not losing your capital in the first place is always better than any insurance policy. Luckily, there are ways to invest in mutual funds without incurring too much risk, all but eliminating the need for federal protection.

One of the chief benefits of mutual funds is their customizability. Most fund managers offer portfolio options that cater to a wide range of investing styles. While stock funds tend to be higher risk, they also carry a greater chance for big profits. However, if you are looking to minimize risk, stock funds are not your best bet.

On the other end of the spectrum are money market mutual funds, which invest only in short-term debt securities, such as government and municipal bonds. These types of investments do not generate huge returns but are backed by the reputation and credibility of the U.S. government, making them highly stable. Often referred to as cash equivalents, money market funds are a great alternative to standard savings accounts.

If you are slightly more risk tolerant but not yet ready to take on the volatility of a stock fund, you can likely find a bond or balanced fund that meets your risk requirements. Bond funds include a variety of corporate and government bond investments. While they are slightly riskier than money market funds, most bond funds are generally considered safe, stable investments. Balanced funds are the most customizable of all because they include both stock and bond investments in a wide range of ratios. This means you can easily find a balanced fund that has just the right amount of risk for your investment style.

Though it is not the same as an FDIC safety net, a little research and some careful planning can enable you to invest in mutual funds with confidence, knowing you minimized risk while still putting your money to work.

(For related reading, see "Can You Become Rich Investing in Mutual Funds?")