Understanding Risk

 

Assessing Fund Performance

Investors in mutual funds purchase shares of ownership in the fund and are entitled to their pro-rata share of the fund’s returns. Except for money market funds, which maintain a fixed price, mutual fund share prices fluctuate and are not guaranteed. The rate of return and the value of an investment account will change based on market conditions. When looking at fund performance, keep in mind that these are past results, used to illustrate a particular fund’s record of return, and is no indication of how it will perform in the future. Here are some simple rules to help assess mutual fund performance.

Compare

Compare funds that have the same investment objectives. For example, a large company growth fund and a small company value fund will have different performance characteristics.

Evaluate

Evaluate how a mutual fund performs relative to its benchmark. A benchmark is often an index of companies that represent an investment category, such as the Dow Jones Industrial Average, S&P 500 or Russell 2000 Index.

If you are comparing the performance of several funds, be sure that you are making accurate comparisons: compare funds with the same investment objectives and fund policies before you look at the numbers.

Risk and Return

 

All investment involves some degree of risk and there is no guarantee that you will end up with more money when you withdraw your investment than you originally put into it.

Risk refers to the volatility, the up and down movement in the markets that occurs constantly over time. Any action or activity that leads to loss of any type can be termed as risk. Higher risk securities have greater short-term price movement. Over time, this improves the likelihood of greater return. In the short-term, this can be unsettling. Invest in a way that matches your personal risk tolerance.

The longer the investing horizon, the more risk you might take to increase potential return. As the time to use your investment nears, you might place importance on protecting capital and invest in less volatile securities.

It’s important to recognize that different types of securities have different levels of risk associated with them. Your investment choices should be based on many factors, but risk is a key component. Your risk tolerance is the degree of variability in investment returns that you are willing to withstand. Not taking enough risk will limit returns. Taking too much risk can create unexpected, short-term losses, which may cause you to abandon your investment plan at the wrong time. Finding the right level of risk should be an informed, personal decision based on your personal risk tolerance and the length of your investment horizon.

 

Types of Risk

 

Risks that affect your investments come in many forms. Actively managed mutual funds and investment accounts attempt to minimize these risks.


Business Risk

Business Risk refers to the possibility that an issuer of a stock or a bond will experience a loss and/or go bankrupt, or in the case of a bond, be unable to pay the interest or principal repayment. Business risk can be influenced by many factors including competition, government regulations, the economy and more. Mutual funds hold securities of many different companies, which minimizes this risk.

Counterparty Risk

Counterparty risk, also known as default risk, occurs when a party does not live up to its contractual obligations. It is a risk to both parties involved in a financial contract and should be taken into consideration when evaluating it.


Credit Risk, Default Risk

Credit Risk, Default Risk refers to the possibility the issuer of a bond will be unable to make timely principal and interest payments.


Currency Risk

Currency Risk refers to the possibility changes in the price of one currency will affect another. If the value of the U.S. dollar is strong, the value of Non-U.S. securities may decline. If the dollar is weak, the value of a U.S. investor’s Non-U.S. assets may rise.


Interest Rate Risk

Interest Rate Risk refers to the possibility interest rates will rise and reduce the value of your investment. Fixed rate instruments decline in value when interest rates rise. Longer-term fixed-income securities such as bonds and preferred stocks have the greatest amount of interest rate risk, while shorter-term securities such as Treasury bills and money markets are affected less.


Market Risk

Market Risk or systematic risk, refers to risk that affects a certain industry, country or region, usually caused by some factor that impacts a whole segment of securities in the same manner. Diversification through mutual funds that invest in different markets can be an effective tool to manage this type of risk.


Inflation Risk

Inflation Risk refers to the possibility that the value of an asset or income will decline as inflation shrinks the value of a country's currency. Because inflation can cause the purchasing power of cash to decline, investors may want to consider investments that appreciate, such as growth stocks or bonds designed to stay ahead of inflation long-term.


Political Risk

Political Risk refers to the possibility that political unrest; government action, terrorism or other social changes can impact investments.

 

Risk by Fund Types

 

RiskRisk and Return by Fund Type



*Not all bond funds are lower risk than balanced funds
 

Active and Passive Risk

 

While each fund type has its own level of risk (as shown in the chart above), there are different types of risk that vary by whether the funds are actively or passively managed.

For passively managed funds, a professional advisor is not able to manage volatility or take defensive positions in declining markets. The risk to be aware of in this situation is that your investment may be subject to greater losses during general market declines than actively managed investments, which are able to react in a timelier manner.

While an actively managed investment can buy and sell funds depending on market conditions and opportunities, it does not go without its own level of risk. A professional advisor’s use of investment techniques and risk analyses to make investment decisions may fail to perform as expected, which could cause the portfolio to lose value or underperform on investments with similar objectives and strategies.

While risk is a byproduct of investing, outperformance and underperformance have historically moved in cycles. Taking a consistent approach helps to mitigate downside risk, especially as some investors may look at the historical trends and try to buy passive strategies during bull markets (when share prices rise) and active strategies during bear markets (when market prices fall).

 

Personal Risk Tolerance

 

We’re all different when it comes to how much risk we are able to tolerate. As an investor, you need to understand the difference between true risk factors that can affect your investments and the emotional part of risk: how you feel about and how you react to those risk factors. Learning as much as you can about a particular type of investment and the risks associated with it before you invest is essential and only you can decide what level of risk you are able to accept.

Knowing your personal tolerance for risk and recognizing how you feel when the value of your investment moves up and down is one of the basic components of investing. While patience and long-term focus are two of the best ways to grow assets over time, is more difficult for some people than others.

 

Managing Risk

 

While investment risk cannot be eliminated, it can be managed through diversification: holding a variety of different types of securities, as in a mutual fund. Mutual funds are by their very nature, diversified, investing in many different securities within one fund. You can further diversify by selecting one or more different types of mutual funds, or asset classes. Different types of mutual funds have different objectives and different levels of volatility or potential price change, so it helps to offset one objective with another for diversification over type of fund and the level of risk associated with it.

As you build your investment portfolio, remember that it is important to rebalance regularly to be sure you are meeting your goals with the funds you’ve selected. Asset allocation or target date funds do this automatically.

Diversify Managing Risk


A diversified portfolio of investments is the best way to manage risk. This illustration shows how you can structure your investments to balance risk and return potential, depending on your investment approach.