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How to Pick a Mutual Fund – Risk

The final criterion in selecting a mutual fund is evaluating risk.  Investing always involves some risk and there’s no way to avoid it completely.  The trick is to keep the risk to your principal as low as possible, while still bringing in a return that makes your investments grow.  This isn’t too difficult, if you know the major risk factors and how to balance them against the return. 

This is the fifth in a series of five posts on mutual funds.  

Why I Invest in Mutual Funds
How to Pick a Mutual Fund – Return
How to Pick a Mutual Fund – Type
How to Pick a Mutual Fund – Fees
How to Pick a Mutual Fund – Risk

Disclaimer: I’m not an investment professional nor am I licensed to sell securities.  This information is provided for entertainment purposes.  Before investing, you should seek the advice of an investment professional.  I’m not affiliated with nor do I receive compensation from mutual fund companies. 

Asset Diversification

Avoid the Risk Factory

Image by KYZ

One of the great benefits of a mutual fund is that you can have diversification, even with a fairly small investment.  For example, you can’t buy 500 individual stocks for $1,000, but you can buy shares in an index fund.  You can even choose Balanced funds that automatically maintain diversification for you. 

One mistake I have seen (and made myself) is to concentrate in one type of market or asset class at the expense of diversification.  This makes a portfolio much more volatile and prone to losses.  I now avoid sector and specialty funds and instead invest in a more diversified way. 

Market Volatility

A fund’s market volatility is measured by an indicator called its Beta.  The Beta shows how volatile a fund is compared to its benchmark index.  For example, a growth fund with a Beta of 1 would have the same volatility as the S&P 500.  If a fund’s Beta is higher than 1, it is more volatile.  If a fund’s Beta is lower than 1, it’s less volatile.  There are other volatility indicators, including Standard Deviation and R-Squared, but Beta is the easiest to use and understand.

The way the stock market has been acting lately, volatility is on everyone’s mind.  Nobody cares about volatility when the market is rising, but it gets everyone’s attention when it comes crashing down.  People who thought they had a high risk tolerance weren’t so comfortable when the market dropped by 40% in 2008.  Many retirees went back to work and aging workers put off retirement.  In my opinion, market volatility has increased recently because of leveraged derivatives and super-fast trading computers. 

Investors with a low risk tolerance and people who will need their money soon (i.e. retirement and college funds) should avoid funds with a high Beta. 

 

Strength & Stability

The strength and stability of a mutual fund company is important is because mutual funds aren’t insured by the FDIC, like a CD or a bank account.  Mutual funds are insured by the SIPC (Securities Investor Protection Corporation), which is not a government agency, but a private corporation.  The good news is that mutual fund companies rarely become insolvent and the SIPC protects accounts up to $500,000.  The bad news is that I have no idea if the SIPC has sufficient reserves or could refund your deposits promptly.  You are better off investing with a top-tier fund company that has assets and experience. 

I used to invest with a single fund company that had really great 10 year performance.  But, they didn’t have a transaction website or any of the online services.  I didn’t have a lot of money in this fund, so I wasn’t really worried about losing it.  But, accessing my account was like being stuck in the ’80s.  I had to call to invest, look in the paper to get my NAV and wait for a statement to find out how many shares I had.  After a couple of years, their performance started to wane and I moved my account to a larger company. 

I strongly recommend avoiding small mutual fund companies. 

Honesty & Integrity

Some of the funds I owned were involved in The Mutual Fund Scandal of 2003.  Invesco, Janus and a number of other fund companies allowed institutional customers to time the market.  This meant they traded more frequently than was allowed in the fund’s prospectus.  As a small investor, I don’t like the big guys getting an unfair advantage over me.  And, I won’t entrust my money to a company who engages in unethical behavior. 

So, I voted with my feet and transferred my investments to T. Rowe Price.  I’m sure these two multi-billion dollar fund companies weren’t concerned with losing my tens of thousands of dollars, but that’s not the point.  The point is that I expect honest dealings from my fund companies and I refuse to do business with those who bend the rules.  If more investors held this standard, I believe we would see a lot less of these indiscretions on Wall Street. 

The Bottom Line

The bottom line is you can’t control risk; you can only hope to avoid it.  The best way to do this is to steer clear of sensational promises and fast money schemes.  Invest with a company you can trust with your future. 

“Yes, risk taking is inherently failure-prone. Otherwise, it would be called sure-thing-taking.” 

Jim McMahon – Former Quarterback of the Chicago Bears 

Recommended Reading

Squirrelers – Diversification vs. Investing in What you Know
Fools and Sages – Mutual Fund Roundup
Out of Your Rut – Stocks are a Lot Less Risky than you Think

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15 comments to How to Pick a Mutual Fund – Risk

  • I checked out the valuation-indexed investing link that you put at the end – quite interesting. What is your take on that?
    Kevin@InvestItWisely recently posted..Invest It Wisely- Enter the Six Month Giveaway Contest!My Profile

    • Kevin,

      That was a guest post by Rob Bennett on one of my favorite blogs Out Of Your Rut. From what I have seen of Rob’s posts and comments, he is pretty knowledgeable. I thought his article was interesting, so I linked to it, even I don’t agree completely with all of his assumptions. One thing I do agree with is earnings (valuations) drive the stock price, sooner or later.

      I pretty much said what I believe about Indexing and passive investing in my section on Fund Types. I still believe there was an S&P bubble created by the multitude of index investors and they got hammered (as we all did) when the market corrected. There is no big mystery here; once the stock prices start to outpace the earnings, it’s only a matter of time until it corrects.

      Now, Index investors are searching for answers and solutions. One solution, which always becomes popular after a market crash, is to time the market. But, the number of successful market timers over the past 20 years is exactly zero. I can’t remember the investor who said, “it’s easier to pry a pit bull off your ankle than it is to get someone to sell a stock after it has gone up 80%”.

      The bottom line is that there is no magical formula to win in the stock market. And, if there was, everybody would start using it and then it would no longer work. The only things that seem to endure are Growth investing, if you can take your lumps, and Value investing, if you are very patient and disciplined.

  • I like how this article focuses on decreasing risk through diversification and gives an admonishment against easy “fast” money at the end. “Fast money” has ruined so many lives! If it really was that easy, everyone would be doing it.

    • Shawn,

      I’ve tried investing in sectors and paid a heavy price for taking the risk. I hate to see new investors take those kinds of lumps because it can discourage them from investing.

      Bret

  • Thanks Bret. I really need to get back on the writing stick. This whole working full time, three kids and insisting on going to the gym thing is really getting in the way. 🙂

    • Andrea,

      For me, blogging is all about balance. I realized four years ago that I wasn’t going to be able to post every day. I wasn’t even going to be able to post two or three times a week. So, I finally settled on once a week and even that is hard to maintain.

      I’m glad your new job is working out. If it is sucking up most of your time, that means they need you. Taking care of your health and your family is more important than posting. I’m sure you’ll be back in action soon.

  • Bret:

    Thanks for your kind link to the article at Kevin’s “Out of Your Rut” site (this is Rob Bennett, author of the “Beyond Buy-and-Hold” column that runs there Wednesday mornings). Also, thanks for your kind words.

    I wish that I could have gotten here earlier, when the discussion was ongoing, but I only noticed this today.

    I’ll be sure to check back at your blog regularly. I wish you the best of luck with it.

    Rob
    Rob Bennett recently posted..“The Best Way to Proceed Is to Permit Readers to Hear Both Sides and to Decide for Themselves”My Profile

    • It’s hard to keep up with all of the conversations going on in the blogosphere. I comment on a lot of blogs every week and I never want to miss the replies. But, it takes a lot of time.

  • Bret:

    This is Rob Bennett again.

    I tried to send you an e-mail asked whether you have an interest in a Guest Blog Entry responding to the concerns about Valuation-Informed Indexing you advanced in your comment above. I was not able to get the e-mail to go through (the system would not accept the capcha code). I would be grateful if you would let me know your direct e-mail address (you can reach me at hocusreports@Verizon.net) and then I could send the e-mail to you that way.

    Thanks.

    Rob
    Rob Bennett recently posted..“The Best Way to Proceed Is to Permit Readers to Hear Both Sides and to Decide for Themselves”My Profile

  • What did you have in mind?

    Thanks for getting back to me, Bret.

    Bret sent me an e-mail as well as responding here. I’ll shoot you an e-mail, Bret.

    Rob
    Rob Bennett recently posted..“The Best Way to Proceed Is to Permit Readers to Hear Both Sides and to Decide for Themselves”My Profile

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