Evaluating risk when investing in mutual funds

Everything we do—or don't do—has an element of risk to it. When you invest, you risk the possibility that the value of your investments will go down or remain unchanged over time. When you don’t invest, you risk the possibility that inflation will reduce your purchasing power.

Investors would ideally like to avoid risk altogether, but that’s impossible. Risk and return are two sides of the same coin: You can't have one without the other.

So, the question is not how to avoid risk, but how to manage it. Understanding how to evaluate risk can help you make choices that will help you survive changing market environments and work toward your long-term goals—while still being able to sleep at night.

For most investors, the concept of return seems straightforward. Let's say you purchased a mutual fund. You wait a year and then check your investment account—and its value increased by 10%. Great! Your return on the mutual fund for that period was 10%.

That's a feature you can observe directly. But what about the risk you assume to invest in the mutual fund? That's much less obvious. To most investors, investment risk is the possibility that their investment will lose money. However, it can be difficult to actually estimate the probability of losing money.

In theory, the higher the investment risk, the more you can potentially earn, and the lower the risk, the less you can potentially earn, on average. To understand this relationship, you must know your risk tolerance. In other words, how much of a drop in the market can you stomach? If your tolerance is low, you may prefer to invest conservatively. For instance, a significant portion of your portfolio might be in low-risk bond funds and a smaller portion in higher-risk stock funds. Some factors to help you determine your risk tolerance include your investing goals, timeline, life stage, investment amount, and comfort level. There's no right or wrong risk level for any one person. Only you can determine how much investment risk you're comfortable taking.

Knowing your risk tolerance can help you create a personalized investment strategy and will drive how you invest. And remember: Past performance is not indicative of future returns.

Every mutual fund has an investment objective that gives you an overview of each fund's risk level. Some funds focus on growth and have higher risk, while others focus on preserving your principal or generating income but offer lower returns. You can find this information, including risk information, by reviewing the fund's prospectus.

The three most common types of mutual funds are stock funds, bond funds, and money market funds. Most stock funds aim to provide investors with long-term growth and, therefore, tend to be higher risk. If you have a longer time frame and a higher risk tolerance, you might allocate a significant percentage of your portfolio to stock funds for the possibility of higher growth. If you have a shorter time frame and lower risk tolerance, you may focus more on bond and money market funds. However, your returns will also tend to be lower.

Two of the most common measures to determine a mutual fund’s risk versus return level are its standard deviation and Sharpe Ratio.¹

• Standard deviation shows the consistency of a mutual fund’s returns over time. A high standard deviation means that the fund’s returns significantly swing above or below the average. A low standard deviation tends to indicate a more predictable stream of returns, with less dramatic highs and lows.
• The Sharpe ratio is used to compare the risk-adjusted returns of similar mutual funds. For instance, say you're interested in two comparable stock funds that delivered the same 10% annual return over the last 10 years but one has a higher standard deviation than the other. The fund with the higher Sharpe ratio delivered the same 10% annual return, but with less risk.

Companies like Morningstar® and Lipper also play a critical role in helping investors compare the risk levels of various mutual funds. Keep in mind that past performance does not guarantee future results, and every investment should align to your individual goals.

There are some risks you can't avoid because they affect the entire market. All mutual funds face the risk that their overall value will decrease due to changes in the market. This is called market risk or systematic risk. In the case of bond funds, it's also called interest rate risk.

At the same time, there are some risks you can avoid because they affect a specific company or industry.

All mutual funds also face purchasing power risk. That’s the risk that the fund's returns will not keep pace with the rising prices of goods and services. You can't dodge market, interest rate and purchasing power risks because they impact the entire market, not just a single investment.

Aside from the above risks that impact mutual funds across the board, each mutual fund may have its own particular risks which depend on the investments it makes and investment strategies it uses. There are resources to help you identify the specific risks along with the broader market and purchasing power risks, much of which is mentioned in the fund prospectus/prospectus summary.

Risk is an unavoidable part of investing. Much of it can be beyond an individual investor’s control. However, there is one important step you can take that is within your control: building a diversified portfolio.

Variety is essential when it comes to minimizing risk. Mutual funds can be an effective way to spread your money across a variety of holdings to reduce risk, even with a small investment. With one share of a mutual fund, you can invest in hundreds of stocks, bonds, cash, or a combination of those assets.

However, keep in mind that diversification is more than owning a hodgepodge of investments. It also means you need to own investments across different asset classes—for example, Large cap and fixed income mutual funds—that react differently to the same market conditions.

It’s also important to note that diversification works both ways. It can help cushion the downside when markets are declining, but it can also limit returns when markets are rising. Once again, your level of diversification should go hand in hand with your overall tolerance for risk.

1. Sharpe ratio uses standard deviation and excess return to determine reward per unit of risk. The higher the number, the better the portfolio's historical risk-adjusted performance.
2. Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness. Investment-grade refers to bonds rated Baa3/BBB- or better. High-yield (also referred to as non-investment-grade or junk bonds) pertains to bonds rated Ba1/BB+ and lower.