Risk and Return on Mutual Funds

by Mike Parker

Everyone is an expert on mutual fund risk and reward in hindsight. The real challenge is effectively measuring a fund's risks and rewards in advance. Unfortunately, beyond knowing that the market will fluctuate, nobody has a crystal ball that forecasts which way the market, a mutual fund or any individual stock price will move. Risk is the price every investor pays for the opportunity to reap a reward.

Know Yourself

Before you begin to assess a mutual fund's risks and returns, take a good look at your own financial life. How you view risk versus return, sometimes referred to as your investment temperament and investment objectives, determines -- at least in part -- which mutual fund is an appropriate investment for you. For example, a higher risk aggressive growth stock mutual fund might offer a greater potential return than a low risk government bond fund, but if you can't sleep at night because you are worried that your aggressive growth mutual fund might lose money, the higher potential return might not be worth the anxiety.

Risk Vs. Reward

"The greater the risk, the greater the reward," the old saying goes, but that's not entirely accurate. A more accurate statement would be "the lower the risk, the lower the reward." Greater risk is typically required to achieve greater reward, but greater risk certainly doesn't guarantee a higher return on your investment. Sometimes greater risk is just a greater risk.

Volatility

Mutual fund risk can be boiled down into one word: volatility. Volatility is nothing more than the up or down price movement of your mutual fund's net asset value. A fund's volatility is determined by a number of statistical calculations that measure the fund's price performance relative to different benchmarks, such as the S&P 500. A fund's volatility is affected by both systematic and unsystematic factors. Systematic risks are those that affect the entire market, such as changes in the U.S. government's monetary policy. Unsystematic risks are those that are unique to the particular fund, such as the fund manager's decision to buy or sell a particular stock.

No Guarantees

Life might offer a few guarantees, but mutual fund returns are not among them. While a long history of consistent returns in both up and down market cycles might be a good indication of a mutual fund's performance, it does not guarantee continued profitability in the future. Mutual funds offer a number of advantages over single security investments, such as professional management of your money and diversification of your investments. But mutual funds are not insured by the Federal Deposit Insurance Corporation or any other federal agency, even if the securities held in the fund might be insured. All mutual fund investments involve risk, and you could lose some or all of your investment.

About the Author

Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.

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