Saturday, March 2, 2013

Risk and Reward in Mutual Fund Investing

By Amy E. Buttell 

Investing in mutual funds and common stocks has its risks and rewards. Generally speaking, when investing in mutual funds, risk and reward are directly related. 

The more risk you're willing to take, the greater your potential reward. The less risky the investment, the less return you will receive. In a very real sense, the risk is not so much that you will lose money; it's more that you will not make the return you should with a reasonable risk. 

The least risky type of mutual fund investment is the money market fund, which pays a varying rate of interest on your money. You generally know about how much your fund will return, and there isn't a lot of risk.

There is less risk involved in a money market fund than in just about any other type. However, while you don't have to worry so much about losing money in a money market fund (the recent financial crisis being an exception), the fund may not produce enough reward for you to meet your long-term financial goals.

To receive a higher financial reward for investing your money, you need to take on additional risk.

Short- and intermediate-term bond funds offer more reward, but with slightly more risk than money market funds. Long-term bond funds and balanced funds are moderately risky and offer more rewards than short and intermediate bond funds.

Moving up to a higher risk and higher reward are growth and income stock funds followed by growth stock funds and aggressive-growth stock funds. History has shown that investing in stocks whether directly or through mutual funds has rewarded investors with higher returns than investments in bonds, money market funds, or cash.

Before you invest, determine how much risk you are willing to take to reach your objectives. The further away those objectives are in time, the more risk you can assume in your investments.

If, for example, you're investing for retirement and have 10, 20, or more years to go, you can choose more aggressive investments with potential high returns over time. Volatility is not a risk to the long-term investor. The market's bias toward growth overcomes volatility with time.

Risk and Fund Types 

Your appetite for risk should directly correlate with the types of mutual funds that you invest in. It wouldn't make sense for conservative investors to put all their savings in an aggressive-growth fund.

Also, because the distinctions between types of funds have become increasingly blurred over the past few years, you can't assume that a fund is actually what it bills itself to be.

That is, a fund with the word "balanced" in its name may or may not actually be a balanced fund in the truest sense of the term. Therefore, you need to carefully examine the fund's prospectus and record before investing.

We recommend that you research the basic data of funds to learn more about ones that interest you. Perhaps check out a mutual fund newsletter to gather more information. By examining a fund's portfolio and the division of its assets between stocks, bonds, and cash, you can usually determine whether a fund is following its stated objective.

If the balanced fund you are interested in actually invests 50% of its assets in small-cap foreign stocks, you'll know that it isn't truly a balanced fund, but rather a small-cap global aggressive-growth fund.

As far as stock funds go, choices between the two extremes of safety and risk, in ascending risk order, include: 

  • Fixed-income funds, offering yield and price stability.
  • Stock income funds, primarily dedicated to producing a relatively steady stream of income.
  • Growth and income funds, which give almost equal attention to both growth and income.
  • Growth funds, with an orientation toward long-term capital appreciation. 


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