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Mutual Funds and Risk
A general rule of investing is that the higher the risk, the higher the potential for gains (and losses), and the lower the risk, the lower the potential for gains (and losses), so it is important to consider the following:
- Risk varies from one fund to another. You can measure risk by a fund’s volatility – the frequency and size of change in the fund's value. The bigger and more often the changes, the more volatile the fund.
- Every fund has a different degree of volatility, depending largely on what the fund invests in. For example, if a fund invests only in interest-paying money market instruments offered by the Canadian government, there will be very little volatility because the government guarantees to pay a certain interest rate and there's little chance it will fail to keep its promise.
On the other hand, some funds invest heavily in technology stocks. Technology stocks can have frequent, large changes in value as their products go in and out of favour, so funds that invest mostly in technology stocks can be quite volatile.
- Holding a wide variety of investments is the key to reducing the overall volatility of your portfolio.
- How long you're prepared to invest. The more time you have until you need to cash in your investments, the more you should think about investing in funds that specialize in stock investments, also known as equities. These can be volatile in the short term but, over the long term, they've tended to provide higher returns than other kinds of investments.
- Your investment goals are unique and will influence how your risk tolerance. If you can reach your goal only by earning higher returns on your investments, think about taking on more risk by making more volatile funds a larger part of your portfolio.
- Your portfolio as a whole. A fund that may seem too risky on its own may be suitable as a small percentage of your portfolio. Why? Diversification. When you hold a variety of fixed income and equity funds in your portfolio, you increase the safety of your portfolio. At the same time, a good mix of investments tends to reduce wide swings in the value of your portfolio. That's because the various kinds of investments the funds hold tend to react differently to market and economic changes.
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