Mutual funds attempt to lower the risks associated with investment through diversification. Even if one or two of the fund's holdings crash completely, the fund itself will not flat line and can still even generate a profit. However, mutual funds are not immune to risk. It is commonly assumed that higher risk means higher returns, but this is not always true. It's best to closely scrutinize the possibilities for risk and return before investing in any fund.
Some risk is involved in every investment. Necessary -- or systematic -- risk in mutual fund markets refers to such events as financial crashes, the failure of entire sectors of the market and interest rate fluctuation. These risks cannot be completely eliminated in any setting. The quality of the investments, strategies employed by the fund and management play no part in this level of risk. Even with the safest mutual funds, there is no way to guarantee completely risk-free investments.
Some risk is avoidable, and you should check on what any fund is doing to minimize these risks before trusting it with your money. Factors that increase risks include poor management, skewed information and generally problematic operations. Under these circumstances even funds that have a historically lower risk, such as bonds, do not perform well. To be sure the managers pay off your earnings as promised, vet your mutual fund to determine its credit risk and look for exorbitant fees that lower your returns.
Measuring Risk and Returns
It's possible to measure the risks and returns involved in any mutual fund. The Sharpe ratio is a measurement used to calculate how many units of return any investment offers per unit of risk. The higher the ratio is, the more worthwhile the investment is given the risk it involves. Another measure is standard deviation, which shows how much a fund tends to stray from its own average performance or how volatile it is. This is useful because even a fund that outperforms the market in terms of returns might have horrendous slumps every few years. Both of these measures become more accurate over long periods.
Making a Decision
Different people have different tolerances for risk, which means that no investment is a wrong choice, except for the one you jump into without consideration. Risk does tend to correlate with return, but that doesn't mean you can't make good money while being prudent. For example, hedge funds tend to make a few people very rich, but if you get there late, you are likely to take a high risk for poor returns. Strategy, market savvy and close observation can diminish your risk. For example, even if the market is crashing, you can make money by using short positions. Detailed familiarity with any mutual fund's strategy and operations is the most effective way to determine what's worth the risk.
Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."