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Managing Risk Through Mutual Funds

April 20, 2012 | Comments: 0 | Views: 139

Does the current stock market volatility make you want to stick your head in the sand and forget about it? Don't despair!

If you read last month's article "Risk is a Four Letter Word", then you know that investing always carries some form of risk; whether market risk, company/industry risk, currency/country risk, reinvestment risk, interest rate risk, liquidity risk or inflation risk. While you can't eliminate risk entirely, there is a way to minimize these risks so that you can sleep well at night. Mutual funds are one such way that the small investor can participate in various investment vehicles while reducing risk.

Equity Funds

Otherwise known as stock funds, equity funds are a pool of funds which invest in various companies on the stock exchange. Instead of buying a share of stock, you are purchasing a share of the fund based on the net asset value (NAV) of all of the stocks within that fund. This NAV will fluctuate each day based on the change in price of the underlying stocks held by the fund. Depending on the type of equity fund chosen, compared to buying individual stocks, an equity fund allows you to reduce the exposure to any company/industry risk, currency/country risk, liquidity risk, and possibly inflation risk as equities are thought to keep pace with inflation over the long term.

There are passive and active equity funds from which you may chose. Simply put, passive funds refer to index funds which track one of the major market indices such as the Toronto Stock Exchange (TSX). Because there is no active trading and analysis of the underlying stocks, fees for index funds are generally much lower than for active funds. Active funds, on the other hand, are actively managed by the portfolio manager, and can be categorized by their investment style, company size, and geography.

Bond Funds

A bond is quite simply a loan to an entity, such as a corporation or government, which borrows an amount of money for a set period of time at a fixed interest rate. Similar to equity funds, bond funds, or fixed income funds, will also have an investment style to which they adhere when choosing the underlying investment. However, a bond fund invests primarily in government, corporate, municipal and convertible bonds, as well as other debt instruments. Also, like equity funds, an investor purchases a share of the fund, which provides diversification of the type of bond, maturity, class and rating.

Compared to purchasing individual bonds, a bond fund may help to reduce reinvestment risk and interest rate risk, in addition to liquidity risk, company/industry risk, and currency/country risk. Inflation risk may still be a factor in a low-interest rate environment. A word of caution though - interest rate risk will remain in a period of rising interest rates because current bond values will fall as a bond paying 5% is now worth less than a newly issued comparable bond offering 7%.

Balanced Funds

That leaves market risk, which is the risk that the entire equity market will be affected by negative news. Usually the equity and bond markets are inversely correlated and this past year was a perfect example. While the TSX fell 11% over 2011, the bond market performed exceptionally well. Therefore, to minimize market risk, a balanced fund offering both equities and bonds can help to ease the fear many people now have since the crash of 2008, or you can use some combination of equity and bond funds in the proportion in which you are most comfortable.

There are literally thousands of mutual funds available for your choosing. Get informed, ask questions, be sure of your own risk tolerance, have a look at the history of the fund, the fees (MER - management expense ratio) and any commissions involved. As with any investment, don't put your money into anything you don't understand, and be sure to read the details of the plan before committing. Be sure you understand the risks and potential returns involved.

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Source: EzineArticles
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