What Are The Risks Involved In Mutual Funds? A Guide

With every investment comes risks we can’t avoid. A mutual fund is an investment strategy that combines money with other investors for a specific purpose. Mutual funds are considered less risky investment vehicles than other options – but that doesn’t mean they’re risk-free.

Let’s dive in and explore what mutual funds are and their risks, along with how to protect your portfolio and its dividends.

What Is A Mutual Fund?

Mutual funds allow investors to pool their money with other shareholders to buy stocks and bonds. Pooling money allows smaller investors to access a wide array of stocks and bonds they usually wouldn’t have access to. Mutual funds are typically used by investors looking for ways to build their retirement accounts.

One of the biggest benefits of mutual funds is that they are overseen by professional portfolio fund managers who constantly monitor mutual fund portfolios to ensure they’re performing as expected. Portfolio managers develop a strategy for the fund based on the goals of its shareholders.

Types Of Mutual Funds

There are different types of mutual funds, and each has its risks and rewards. Mutual funds fall into three main categories: equity funds, fixed-income funds and balanced funds. Some funds are more aggressive in their investment strategy and invest in companies that are typically viewed as risky. For shareholders with a lower risk tolerance, work with the portfolio manager to ensure your money is in funds with proven track records and consistent returns.

Depending on your goals, timeline and risk tolerance, there are several mutual fund investment options to pick from.

In addition to these examples, there are many other types of mutual fund out there. Some are more passively managed, like index mutual funds, while others might be higher risk, like commodity funds. Talk to a financial professional to decide which funds are right for your goals.

Why Are Mutual Funds Considered A High-Risk Form Of Investment?

Any investment strategy is bound to have risks. While some mutual fund investments are higher-risk than others, because portfolio managers typically invest them in a variety of stocks and bonds, they are a well-diversified option.

In the investing world, risk tolerance refers to how much risk you’ll permit in your investment strategy.

Not all investment products are equal, and some investments experience more volatility than others.

Below are six risks connected to mutual funds:

• Market risk: The risk of losing some or all of your principal. As markets fluctuate, there is always a possibility that your mutual funds may drop in value.
• Inflation risk: The risk of losing purchasing power. For example, if your mutual funds gain 4% in a year but the cost of living goes up 2%, your true investment return will be 2%.
• Interest rate risk: The risk that rising interest rates will cause the value of your mutual funds to sink. Bond prices typically drop when interest rates rise, which can likely trigger a decline in bond-heavy mutual funds.
• Currency risk: The risk that a decline in the currency exchange rate will shrink your gains or add to your losses.
• Credit risk: The risk that whomever issued the security won’t have the money to pay out interest or to redeem them at face value when they come due. This risk is typically higher for securities that “promise” higher returns.
• Liquidity risk: This is the risk that a fund, based on its marketability, won’t be bought or sold fast enough to meet its financial goals.

How To Determine And Measure Risk

Systemic risk, also known as an “undiversifiable risk” or “market risk,” affects the overall market, not a particular stock or industry.

It’s important to pick a realistic strategy you can follow and live comfortably with. Risky investments tend to have higher returns – but make sure you can afford the risk. You shouldn’t make decisions based on fear or pressure to perform.

Some common measures of risk include:

• Standard deviation: Standard deviation measures fluctuations around the average return of an investment. The higher the standard deviation, the higher the risk and vice versa.
• Alpha: This metric measures the performance of an investment portfolio against a benchmark index. A positive alpha ratio means a portfolio has outperformed its benchmark by at least 1%. A negative alpha ratio means the portfolio has underperformed by at least 1%.
• Beta: Beta measures how a stock will respond to volatility or movement in the stock market.
• Value at risk (VaR): VaR estimates the potential for loss in a fund and the probability the loss will happen. VaR is measured by forecasting risk, estimating the probability it will happen and calculating the extent of the loss and its time frame.

What Are The Advantages Of Mutual Funds?

There are many reasons investors choose to invest in mutual funds. Below are some obvious and not-so-obvious advantages:

• Advanced portfolio management: When you invest in a mutual fund, a portion of your fees is used to hire a professional portfolio manager. The manager’s only job is to monitor the health of the portfolio. Their job depends on the performance of your investments.
• Dividend reinvestment: Investors can use dividends and other interest income to purchase additional shares in a mutual fund to help grow their investment faster. Reinvestment in a well-performing fund is a common growth strategy.
• Risk reduction: Mutual funds are incredibly diversified. Most mutual funds invest in 50 – 200 securities, depending on the portfolio’s strategy and market conditions.
• Convenience and fair pricing: Mutual funds have lower minimum investment requirements. Because they trade once a day after the market closes, you won’t see constant price fluctuations.
• Liquidity: Mutual funds are easier than other long-term investment vehicles to buy and sell. If you’re ever in need of cash, you can redeem your funds rather quickly.

How Can I Protect My Mutual Fund Investments?

No investment is safe from risk. It’s an inherent part of the investing process. But there are a few ways you can help protect your investments:

• Choose bond funds: Bonds provide returns of principal and guaranteed interest payments every year. Bonds are fixed-income loans made by an investor to a borrower. The borrower is typically a corporation or government entity.
• Avoid leveraged funds: Mutual funds have restrictions on the amount of leverage they can hold. Leveraged funds are borrowed capital, or in other words, debt, that can help multiple the potential returns from a fund. The maximum amount of money a fund can borrow is 33% of its total portfolio value. If you’re investing for the long term, you may want to keep leveraged funds and other risky debt products out of your portfolio.
• Reduce risk: Money market funds are considered the most stable funds. These funds invest in short-term debt issued by the U.S. government or highly rated corporations with a low risk of default.

The Bottom Line

Mutual funds play an important role in the investment landscape. While mutual funds aren’t as risky as other investments, they have downsides, too.

When you invest, minimal risk attracts minimal rewards. Hedging your portfolio with “safer” bonds and stocks can help maintain balance in your investment portfolio, but it may take longer to reach your financial goals. Consider talking to a financial advisor before you make any investment decisions.

Want to learn more about managing your finances? Check out other personal finance articles on Rocket Money℠.