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The Financial Planning Center

Comprehensive Financial Planning

Mutual Fund Risk

Mutual Fund Education

Why Mutual Funds?

What is a Mutual Fund?

How Mutual Funds Work

Mutual Fund Risk

Advantages/Disadvantages

Mutual Fund Expenses

Costs you Wont Find in a Prospectus

Mutual Fund Categories

Fund Management Styles

How an Investment in a Mutual Fund Makes Money

Investment Company Act of 1940

Where to Purchase Funds

 Future Value Chart

Risk

Every type of investment, including mutual funds, involves risk.  Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment.  A fund's investment objective and its holdings are influential factors in determining how risky a fund is.  Reading the prospectus will help you to understand the risk associated with that particular fund. 

Generally speaking, risk and potential return are related. This is the risk/return trade-off.  Higher risks are usually taken with the expectation of higher returns at the cost of increased volatility.  While a fund with higher risk has the potential for higher return, it also has the greater potential for losses or negative returns.  The school of thought when investing in mutual funds suggests that the longer your investment time horizon is the less affected you should be by short-term volatility.   Therefore, the shorter your investment time horizon, the more concerned you should be with short-term volatility and higher risk.

How do the professionals manage risk?  click here  

Defining Mutual fund risk

Different mutual fund categories as previously defined have inherently different risk characteristics and should not be compared side by side. A bond fund with below-average risk, for example, should not be compared to a stock fund with below average risk. Even though both funds have low risk for their respective categories, stock funds overall have a  higher risk/return potential than bond funds.

Of all the asset classes, cash investments (i.e. money markets) offer the greatest price stability but have yielded the lowest long-term returns. Bonds typically experience more short-term price swings, and in turn have generated higher long-term returns. However, stocks historically have been subject to the greatest short-term price fluctuations—and have provided the highest long-term returns.  Investors looking for a fund which incorporates all asset classes may consider a balanced or hybrid mutual fund.  These funds can be very conservative or very aggressive.  Asset allocation portfolios are mutual funds that invest in other mutual funds with different asset classes.  At the discretion of the manager(s), securities are bought, sold, and shifted between funds with different asset classes according to market conditions.

Mutual funds face risks based on the investments they hold. For example, a bond fund faces interest rate risk and income risk.  Bond values are inversely related to interest rates.  If interest rates go up, bond values will go down and vice versa.  Bond income is also affected by the change in interest rates.  Bond yields are directly related to interest rates falling as interest rates fall and rising as interest rise.  Income risk is greater for a short-term bond fund than for a long-term bond fund.

Similarly, a sector stock fund (which invests in a single industry, such as telecommunications) is at risk that its price will decline due to developments in its industry. A stock fund that invests across many industries is more sheltered from this risk defined as industry risk.

Following is a glossary of some risks to consider when investing in mutual funds.

• Call Risk. The possibility that falling interest rates will cause a bond issuer to redeem—or call—its high-yielding bond before the bond's maturity date.

• Country Risk. The possibility that political events (a war, national elections), financial problems (rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country's economy and cause investments in that country to decline.

• Credit Risk. The possibility that a bond issuer will fail to repay interest and principal in a timely manner. Also called default risk.

• Currency Risk. The possibility that returns could be reduced for Americans investing in foreign securities because of a rise in the value of the U.S. dollar against foreign currencies. Also called exchange-rate risk.

• Income Risk. The possibility that a fixed-income fund's dividends will decline as a result of falling overall interest rates.

• Industry Risk. The possibility that a group of stocks in a single industry will decline in price due to developments in that industry.

• Inflation Risk. The possibility that increases in the cost of living will reduce or eliminate a fund's real inflation-adjusted returns.

• Interest Rate Risk. The possibility that a bond fund will decline in value because of an increase in interest rates.

• Manager Risk. The possibility that an actively managed mutual fund's investment adviser will fail to execute the fund's investment strategy effectively resulting in the failure of stated objectives.

• Market Risk. The possibility that stock fund or bond fund prices overall will decline over short or even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods when prices fall.

• Principal Risk. The possibility that an investment will go down in value, or "lose money," from the original or invested amount.

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