Investing in Mutual funds: Risk Classification of Mutual funds
To start off, a Risk Classification System developed by Global Consulting Firm William M. Mercer, splits risk into two categories, Equity Risk and Focus Risk.
Different mutual funds invest different proportions of their funds in stock, bonds and fixed income. The greater the amount invested in stocks, the higher the equity risk. This is because stock is perceived to be the most volatile of all investments.
The equity risk of mutual funds can be split into four categories.
- Lower Risk
- Low to Medium Risk
- Medium to High Risk
- Higher Risk
Mutual funds with a higher Equity Risk classification usually perform better than those with lower Equity Risk over a longer period of time. However, higher risk mutual funds are also more susceptible to short term losses.
You should remember that the four categories are just a very simplistic guide to risk and there are many other factors which affect a mutual fund's volatility and performance.
In addition to equity risk, we can split mutual funds by focus risk. This depends on how much of the mutual fund's investment is devoted to a particular region or sector. The less diversified a mutual fund is, the greater is its Focus Risk.
For example, a mutual fund that is invested in only one country or sector is susceptible to changes in that ONE particular region or sector, and can thus have greater fluctuations. A mutual fund that is invested over a wide range of countries and sectors has less Focus Risk, as a bad performance in one area can be offset by a good performance in another.
When considering Focus Risk, a mutual fund can fall anywhere between Broadly Diversified and Narrowly Focused, depending on how well it has diversified its geographical and sectoral risks.
Broadly Diversified mutual funds invest in a wide range of regions, countries and sectors. The words 'Global' or 'International' in them are usually good clues to them being broadly diversified.
It's Your Choice!
This risk classification system is just one of many such systems around. Various financial institutions have their own systems and own ways of classifying risk and returns.
We have our own risk rating system. We assign a risk rating to every fund to indicate the level of riskiness. The risk rating is based on the
- Type of asset allocation, i.e., to what degree is a fund invested into equities, bonds, etc.?
- Degree of diversification, i.e., is the fund broadly diversified or narrowly focused?
- Volatility of the fund's returns
What YOU have to do is decide for yourself which type of mutual fund appeals to you most, and follow the basic rules of investing.
Next : Determining your risk levels