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How can mutual funds help manage financial risk?
In business and investment, more significant gains are associated with both business success and variable risk. Six risk factors are examined below, along with constructive ways to deal with them.
Risk increases with the potential for gaining wealth in the markets
There is no such thing as gaining wealth without risk. Risk generally increases within any business or investment when the potential for gain is greater. Mutual funds diversly invest in the stocks of many companies. If a business succeeds, its stock price (and dividends) can increase in value and pass that worth on to the fund unitholders.
If many companies’ stocks increase in value in a mutual fund, the investor’s wealth can increase relative to the resulting total net increase in all of the fund unit’s value. In the short term, a mutual fund, like any business, can fluctuate in value, so the risk of losing money in the stock market increases if equity fund investments are held for only a short period.
Defining Investment Risk
The potential for gain generally increases the longer you hold equity fund investments. Because economic performance is uncertain, an investor who seeks growth by investing in the ownership of companies via equity mutual funds cannot have zero risk. Most successful investors realize that the following risks exist yet invest despite these:
• Interest rate risk when increasing could negate gains of certain income funds investing in bonds.
Solution: Maintain a balanced portfolio including equity funds and different types of income funds: money market, short-term bond, and long-term bond funds.
• Business failure risk could deplete the value of any one company’s stock.
Solution: Consider investing in equity mutual funds because they hold many different stocks.
• Purchasing power risk is an alarming reality faced by everyone due to inflation’s historical average, which has been between 3% and 4%.
Solution: Calculate inflation into your retirement planning and consider investing in equity mutual funds over the long term, with the potential to build sufficient wealth to meet increased future budget demands due to inflation.
• Market risk occurs because markets are cyclic, rising, correcting, and occasionally declining.
Solution: Diversify your funds, investing in a family of domestic mutual funds and internationally among foreign mutual funds as not all markets move together.
• Opportunity risk occurs when you cannot invest your money for a potentially better return, such as when you are invested in a locked-in type of investment, such as term deposits, or have tied up your income in monthly payments.
Solution: Try not to lock up all of your money, keeping some in money market funds over any given period.
• Liquidity risk occurs when you cannot quickly sell a given investment, such as an extensive real estate portfolio.
Solution: Invest in mutual funds. If money is urgently needed, funds can be sold and money accessed on any business day with possible costs.
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