How can mutual funds help manage financial risk?
More significant gains are associated with both business success and variable risk in business and investment. Six risk factors and constructive ways to deal with them are examined below.
Risk increases with the potential for gaining wealth in the markets
There is no such thing as gaining wealth without risk. Risk generally increases within any business or investment when the potential for gain is more significant. Mutual funds diversely invest in the stocks of many companies. If a business succeeds, its stock price (and dividends) can increase and pass that worth on to the fund unit-holders.
If many companies’ stocks increase in value in a mutual fund, the investor’s wealth can increase relative to the resulting total net increase in the fund unit’s value. In the short term, a mutual fund, like any business, can fluctuate in value, so the risk of losing money in the stock market increases if equity fund investments are held for only a short period.
Defining Investment Risk
Because economic performance is uncertain, an investor who seeks growth by investing in the ownership of companies via equity mutual funds cannot have zero risk. The potential for gain generally increases the longer you hold equity fund investments. Most successful investors realize that the following risks exist, yet invest despite these:
• Interest rate risk, when increasing, could negate gains of certain income funds investing in bonds.
Solution: Maintain a balanced portfolio including equity funds and different types of income funds: money market, short-term bond, and long-term bond funds.
• Business failure risk could deplete the value of any one company’s stock.
Solution: Consider investing in equity mutual funds because they hold many different stocks.
• Purchasing power risk is an alarming reality everyone faces due to inflation’s historical average, between 3% and 4%.
Solution: Calculate inflation into your retirement planning and consider investing in equity mutual funds over the long term, with the potential to build sufficient wealth to meet increased future budget demands due to inflation.
• Market risk occurs because markets are cyclic, rising, correcting, and occasionally declining.
Solution: Diversify your funds, investing in a family of domestic mutual funds and internationally among foreign mutual funds, as not all markets move together.
• Opportunity risk occurs when you cannot invest your money for a potentially better return, such as when you are invested in a locked-in type of investment, such as term deposits, or have tied up your income in monthly payments.
Solution: Avoid locking up all your money, keeping some in money market funds over any given period.
• Liquidity risk occurs when you cannot quickly sell a given investment, such as an extensive real estate portfolio.
Solution: Invest in mutual funds. If money is urgently needed, funds can be sold and accessed on any business day with possible costs.
