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How to Invest in Mutual Funds: Risk and Returns

Many investors constantly look for new ways to increase the returns on their mutual fund investments. When investing in mutual funds, investors must strike a balance between maximizing their portfolios’ performance and not taking on excessive market risk.

Striking this balance can be tricky and is often affected by a variety of scenarios:

The Perils of Market Timing

Investors frequently attempt to boost their portfolio returns by trying to time the market, which means that they try to enter or exit positions in advance of market swings. Even for professional investors, this is often a losing strategy. There is no way to predict the perfect time to buy and sell.

Though an investor’s funds may lose their value in a down market, they won’t lose their cost basis. In other words, if you exit a position at a loss, you lock in the loss, rather than remaining invested until the position tracks back into positive territory. Making things worse for market timers, fear often holds investors back from buying as the market declines, while overconfidence can cause us to hold on to a mutual fund for too long during a bull market. (For more, see: Analyzing Mutual Fund Risk.)

Bear markets aren’t going away. And even the best stocks can lose significant value. While investors live by the motto to “buy low and sell high,” attempting to time the market can force them to assume costs in the forms of transaction fees and taxes (assuming that they realize gains). Plus, while mutual funds offer appealing diversification benefits for buy-and-hold investors, their multi-holding structure means that they frequently cost more to trade than exchange-traded funds (ETFs) or equities.

Understand Your Risk Tolerance

Rather than trying to time the market, investors should work to better understand the role that their emotional intelligence plays in identifying what level of risk they are comfortable with across market conditions.

One of the most important success indicators of mutual fund investing is having a healthy understanding of the risk that you’re willing to take. This helps investors set reasonable performance expectations and steers them away from flash points that can override sound judgment. As a jumping off point, it may make sense to think about what behavioral profile fits you best:

  • Avoiders: These people are often most concerned about avoiding loss. Listening to that inner self helps them avoid reacting for the sake of a crisis. But settling for less return to avoid a loss can hinder their long-term investment performance.
  • Mitigators: These investors are more likely to take risks after thoroughly investigating them. Though they generally have diversified portfolios, they can be overly nervous and hold themselves back because of market fluctuations.
  • Managers: These confident investors tend to view themselves as savvy. As a consequence, they run the risk of letting their confidence blindsiding them.
  • Seekers: For some investors, thrill seeking and excitement are catalysts for taking greater risks than they may be able to handle.

Your approach to investing can impact the health of your portfolio. Self aware investors can improve their outcomes by striking a balance between maximizing their mutual fund performance and refraining from taking on too much risk. (For more, see: Choose a Fund With a Winning Manager.)

How to Choose Mutual Funds

Beyond analyzing their own emotional triggers, investors should pay close attention to the mutual fund managers that they’re considering investing in. When selecting mutual funds, investors should compare the returns of the funds across the same time period, as well as keeping in mind these six steps:

  1. Understand the peer category a fund falls in: Fund rating companies, such as Morningstar and Lipper, group funds with similar characteristics together. For example, Lipper has 155 classifications for funds that include categories such as large-cap value, alternative long/short, etc. Investors should dig into the fund to make sure that it is classified correctly, what investments actually make up the portfolio and make an independent determination as to whether or not the fund achieves the appropriate goal in their portfolio.
  2. Calculate annualized percent return: This so-called “geometric return” is an abstract number, since actual returns vary year to year. However, investors can annualize a fund’s return over time to help facilitate peer-to-peer comparisons. This return calculation reflects reinvestment of dividends and capital gain distributions, while deducting fund expenses and fees. It excludes any sales loads.
  3. Review maximum drawdown: This can be a frightening step, but it pays to understand how far a fund has fallen under past stresses and how long it took to recover.
  4. Screen for high standard deviation: Standard deviation is a measure of fund volatility. The higher the standard deviation of the fund, the more its return has varied over time. Comparing two managers in the same peer category, who post similar returns but have significant differences in standard deviation, can help investors understand how smooth the ride was to the same destination.
  5. Sharpe ratio: The sharpe ratio measures risk-adjusted return. It is a calculation that helps investors understand whether the fund is generating returns commensurate with the risk taken. The calculation divides the fund’s annualized excess return by its standard deviation. In this case, “excess return” is any amount above risk-free investment, typically 90-day U.S. Treasuries. Investors should generally look for funds that consistently rank in the top 25% of their peer group.
  6. Martin ratio: Similar to the sharpe ratio, the martin ratio measures excess return relative to typical drawdown. This ratio can help investors narrow in on managers that deliver superior returns while mitigating downside losses. Again, investors should look for funds that consistently rank in the top 25% of their peer group.

By comparing multiple managers in the same asset category over a similar time period, investors can hone in on the quality funds that have performed well, consistently.

Invest in Mutual Funds for the Long-Term

We’re in the later stages of a very long bull market. If you’re getting nervous and already have a risky portfolio, it may make sense to mix in some fixed income, dividend-paying blue-chip stocks or other stable, diversifying investments. As you get more comfortable with the trajectory of your portfolio, it may make sense to re-engage with more risk. This strategy should keep you focused on the long term, because exiting completely in anticipation of a bear market is rarely a good strategy.

It may also make sense to engage a financial advisor if you have not already. While they do provide investment advice, advisors can also help you find a holistic approach to manging your money that will help you better understand your blind spots and reassess the risks that you’re taking. (For more from this author, see: 6 Cognitive Biases That Can Derail Your Portfolio.) 

Disclosure: Kris Maksimovich is a financial advisor located at Global Wealth Advisors 18170 Dallas Parkway, Suite 103, Dallas, TX 75287. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.