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Mutual Funds
Risk vs Reward |
Risk is a fundamental part of investing. All
investments involve some degree of risk at one time or another. Even FDIC-insured bank
accounts have the risk of not being able to keep up with inflation.
With mutual funds, it's possible that what you take out may not match what you've put in
-- in fact, it may be less. Lower returns and losing money are two of the greatest risks a
mutual fund investor can face.
If you want higher returns though, you must be willing to accept a higher amount of risk.
That doesn't mean you have to hedge your investments with futures, options or other
derivatives. But it does mean you have to carefully weigh the risks against the rewards --
and find a balance that you're comfortable with.
Four things you can do to manage risk better:
1. Understand the basic types of risk.
2. Associate risk with the types of funds.
3. Identify your personal tolerance for risk.
4. Learn how to minimize risk through diversification.
Types of Risk
There are a few conditions that influence how risky your mutual fund investments will be:
- Management Risk. A change in management -- your fund manager jumps ship
-- may signal a change in the fund's strategy.
Inflation. Your purchasing power
is diminished, as are the earnings from your investments -- inflation eats away at the
gains you've worked hard to produce.
Market Risk. When the stock or bond markets drop significantly, the
value of your investments drop with them -- and vice versa. Outside factors or other risks
contribute to frequent market swings.
Interest Rate Risk. A change in interest rates has a profound effect on
both stocks and bonds. If the rates go up, the price of bonds decline -- rates are lower
than newly issued bonds. Higher rates also mean increased inflation and a possible decline
in stock prices. Rates are unpredictable.
Political Risk. Political
instability in an emerging nation can wreak havoc on investment returns. Stability, on the
other hand, can lead to strong growth and impressive returns.
Currency Fluctuation. Fluctuations
in the U.S. dollar can affect the value of investments held outside the U.S. (or U.S.
companies with foreign subsidiaries). Foreign countries will experience the same currency
fluctuations.
Risk vs Reward
The following chart should help you identify the risks associated with different
types of mutual funds. Keep in mind -- actual risk vs reward varies with each
individual fund.
Type of Fund |
Risk/Reward |
| Company Stock |
Highest |
| International |
| |
| Aggressive Growth |
| |
| Growth |
| |
| Growth and Income |
| |
| Balanced |
| |
| Bond |
| |
| Money Market |
Lowest |
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