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

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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