Mutual Fund Education Center This section covers mutual fund education designed to
help beginners and professionals alike. There are many aspects of mutual funds an investor should understand before
a mutual fund purchase is made. The information below defines risk, the risks associated with mutual fund investing,
and how different asset class mutual funds have their own unique risk.
Risk
Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you
will lose money (both principal and any earnings) or fail to make money on an investment. A fund's investment
objective and its holdings are influential factors in determining how risky a fund is. Reading the prospectus
will help you to understand the risk associated with that particular fund.
Generally speaking, risk and potential return are related. This is the risk/return trade-off. Higher risks
are usually taken with the expectation of higher returns at the cost of increased volatility. While a fund
with higher risk has the potential for higher return, it also has the greater potential for losses or negative
returns. The school of thought when investing in mutual funds suggests that the longer your investment time
horizon is the less affected you should be by short-term volatility. Therefore, the shorter your
investment time horizon, the more concerned you should be with short-term volatility and higher risk.
Defining Mutual fund risk Different mutual fund categories as previously defined have inherently different risk characteristics
and should not be compared side by side. A bond fund with below-average risk, for example, should not be compared
to a stock fund with below average risk. Even though both funds have low risk for their respective categories,
stock funds overall have a higher risk/return potential than bond funds.
Of all the asset classes, cash investments (i.e. money markets) offer the greatest price stability but have
yielded the lowest long-term returns. Bonds typically experience more short-term price swings, and in turn have
generated higher long-term returns. However, stocks historically have been subject to the greatest short-term price
fluctuations—and have provided the highest long-term returns. Investors looking for a fund which incorporates
all asset classes may consider a balanced or hybrid mutual fund. These funds can be very conservative or
very aggressive. Asset allocation portfolios are mutual funds that invest in other mutual funds with different
asset classes. At the discretion of the manager(s), securities are bought, sold, and shifted between funds
with different asset classes according to market conditions.
Mutual funds face risks based on the investments they hold. For example, a bond fund faces interest rate risk
and income risk. Bond values are inversely related to interest rates. If interest rates go up, bond
values will go down and vice versa. Bond income is also affected by the change in interest rates. Bond
yields are directly related to interest rates falling as interest rates fall and rising as interest rise.
Income risk is greater for a short-term bond fund than for a long-term bond fund.
Similarly, a sector stock fund (which invests in a single industry, such as telecommunications) is at risk that
its price will decline due to developments in its industry. A stock fund that invests across many industries is
more sheltered from this risk defined as industry risk.
Following is a glossary of some risks to consider when investing in mutual funds.
Call Risk. The possibility that falling interest rates will cause a bond issuer to redeem—or call—its
high-yielding bond before the bond's maturity date.
Country Risk. The possibility that political events (a war, national elections), financial problems
(rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country's
economy and cause investments in that country to decline.
Credit Risk. The possibility that a bond issuer will fail to repay interest and principal in a timely
manner. Also called default risk.
Currency Risk. The possibility that returns could be reduced for Americans investing in foreign securities
because of a rise in the value of the U.S. dollar against foreign currencies. Also called exchange-rate risk.
Income Risk. The possibility that a fixed-income fund's dividends will decline as a result of falling
overall interest rates.
Industry Risk. The possibility that a group of stocks in a single industry will decline in price due
to developments in that industry.
Inflation Risk. The possibility that increases in the cost of living will reduce or eliminate a fund's
real inflation-adjusted returns.
Interest Rate Risk. The possibility that a bond fund will decline in value because of an increase in
interest rates.
Manager Risk. The possibility that an actively managed mutual fund's investment adviser will fail to
execute the fund's investment strategy effectively resulting in the failure of stated objectives.
Market Risk. The possibility that stock fund or bond fund prices overall will decline over short or
even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods
when prices fall.
Principal Risk. The possibility that an investment will go down in value, or "lose money,"
from the original or invested amount.
