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How Can A Mutual Fund Reduce An Investing Risk?

Mutual funds utilize a number of different methods which can help reduce overall investing risk. When a mutual fund is created it has certain investment goals in mind and implements those goals as outlined in its prospectus. The prospectus not only spells out characteristics such as management fees and other legal disclosures but also the investment style and inherent risk of the mutual fund.

One of those risks, which applies to all investments, is share price volatility. The volatility of the mutual fund is determined by the types of underlying assets that it is investing and in what percentages those assets are purchased. A tech mutual fund could be as risky as a single high flying tech stock if a mutual fund invests in only a handful of highly volatile technology stocks. This is because the mutual fund has purchased a large number of shares from a small collection of companies and therefore may not be adequately diversified.

The opposite is also true in that a mutual fund could significantly lower overall investing risk by purchasing smaller blocks of shares from a larger number of companies across multiple sectors to achieve a greater level of diversification. A great type of mutual fund which does this is called an index fund which purchases shares from all available companies in a given stock index which will reflect the gains and losses of the index.

Diversification however isn't the only way in which a mutual fund can reduce investing risk. A great feature of mutual funds is something referred to as dollar cost averaging. A number of mutual funds allow investors to make incremental mutual fund purchases at a fixed dollar amount per month. This is a great way to reduce investing risk because purchases are made at fixed periods of time for fixed amounts so investment dollars purchase more shares when prices are low and less shares when prices are high. Dollar cost averaging helps level out per share cost basis and when combined with a long-term investment horizon can lead to better overall portfolio returns.

Diversification and dollar cost averaging already do a great job of reducing investing risk in mutual funds. There is another great characteristic which should be taken into consideration which is that all mutual funds are managed by one or more portfolio managers. These highly educated individuals, often with many years of investment experience, make the decisions that individual investors may not be confident with making regarding investment purchases. Portfolio managers often have access to significantly more financial information combined with years of analytical experience which allows them to, hopefully, purchase industry leading stocks or bonds which small investors may not even be aware of as investment opportunities.

For small investors, mutual funds can be a great way of reducing investing risk by taking away the hand wringing and sleepless nights of making important investment decisions and putting them in the hands of professional portfolio managers. Combined with diversification, dollar cost averaging and a long-term investment horizon, mutual funds allow individual investors to purchase stocks and bonds all while helping to minimize investing risk. All investments have the potential to lose money but mutual funds go a long way to lowering the potential loss while allowing investors to comfortably sleep at night.