Mutual Fund Strategies: How to Minimize the Risk

Before you can plan a mutual fund strategy, you need to have a clear picture in your mind of your goals as an investor. You also need to determine the amount of time you have to reach those goals. Investing is time-sensitive, so you will always need to factor time into any investing strategy.

Today, with more than 10,000 mutual funds to choose from, you can be sure there is a fund (or several) with your name on it. However, rather than seeking a fund or even a fund category, you should first determine how your portfolio should be set up. It is always much easier to start at the top, with your overall asset allocation plan, and then fill in the pieces, or funds, later. Too many investors go right to the fund selection, chasing the top funds as listed in magazines only to get burned when last year’s winner becomes this year’s disaster.

If you determine your overall investing position based on goals and timeframe, you can lay out a strategy. For example, a young couple, without children, who have a high combined income, can be aggressive in their choices. They may opt to put 80 percent of their investment dollars into riskier, aggressive funds and the remaining 20 percent into more conservative fund investments. They have time on their side and are not averse to taking some financial risk.

Conversely, an older couple, nearing retirement, may opt for the reverse calculations, looking for 80 percent of their mutual fund investments to be in income-generating, safer funds. They want income soon and are not in a position to take risks.

Of course, the above examples are broad generalizations. However, by creating your asset allocation blueprint you will then be able to select fund categories that fit appropriately and allow you to diversify. By diversifying across sectors, caps and fund categories, you lower your overall level of risk. In a sense, a good investor is doing at some level what a fund manager does by choosing diverse investments so that, if one does poorly, the others will more than make up for it.

In the late 1990s the technology funds were the rage. If you were willing to take the risk and bank on tech sector funds (and knew when to get out), you could have made a lot of money. While no one sector is flying at that level today, you can take a more aggressive approach by looking at overseas markets and small cap, mid cap and emerging growth funds. In the more conservative portion of the portfolio, you’ll want funds with the large cap blue chip stocks, large cap value funds, income funds and bond funds.

Generally, having five to eight funds in your fund portfolio should meet your investing needs. The key to your strategy is figuring out your timeframe, risk level and asset allocation first before looking at fund categories and finally plugging in the actual funds.

The best strategy, you should consider, is to build a diversified mutual fund portfolio. A properly constructed portfolio, including a mix of both stock and bonds funds, provides an opportunity to participate in stock market growth and cushions your portfolio when the stock market is in decline. Such a portfolio can be constructed by purchasing individual funds in proportions that match your desired asset allocation or you can do the entire job with a single fund by purchasing a mutual fund that has "growth and income" or "balanced" in its name.

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While there are certain diversification strategies that investors can undertake to minimize their risk, there is always the risk that the market as a whole is unhealthy and produces negative returns. The different types of risk inherent with investing and how to avoid them are outlined below:

Systematic Risk

This type of risk is impossible to reduce through diversification. Unfortunately, along with investing in capital markets comes the risk of an overall economic downturn. Since this risk is impossible to eliminate, mutual fund investors tend to focus on the next main type of risk: non-systematic risk.

Non-Systematic Risk

This type of risk is the risk associated with investing in any particular security. This can be a stock, bond, exchange traded fund etc. Fortunately, this risk can be reduced through diversification. As such, many mutual fund investors search to choose a wide variety of securities to include in the portfolio in order to diversify away from this non-systematic risk. However, it must also be noted that after a total of 32 securities are added to the portfolio, the risk has been diversified as much as possible. Any securities that are added to these 32 will not serve the purpose of reducing risk in the portfolio.

Diverse Security Types

Now that we have covered the forms of risk and the need for diversification, we can cover some of the ways to expand proper diversification potential. The first is to invest in different types of securities. Depending on the business cycle, different securities will be most appropriate to the portfolio, however there should always be a mix of these securities so that the investor is not restricted to one particular market. Different security types that some mutual fund investors consider are: bonds (also called debentures in some cases), equities (stocks), exchange traded funds (these follow the performance of a certain market whether it is a stock market or the market for the price of a metal). More experienced investors may choose to invest in stock options or warrants which essentially give the right but not the obligation to purchase a security at a given price.

Diverse Industries

Another strategy to increase the diversification potential of a portfolio is to invest in a diverse number of industries. This will prevent you from being overly exposed to an industry which may experience an overall decrease in profits due to a certain global issue (i.e.: the real estate market). The key here is to invest in stocks that aren't correlated to one another. For example, rather than investing in a cruise company as well as an airline company (both subject to variance in the amount of travel); you should invest in an airline company as well as oil. Since the price oil is negatively correlated to the airline company's profitability (as one rises in value the other should fall), you will be well positioned to reduce the overall risk of your portfolio of securities.

While there are other methods of diversification (i.e.: investing in foreign markets), these are the main ones, and by using this knowledge, you should be able to minimize the risk in your portfolio greatly.

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