Mutual funds are often touted as one of the safer investments available because of their intrinsic diversification and professional management. Mutual funds allow shareholders to pool their funds into products that invest in a wide range of securities to optimize their returns. In addition, the almost infinite variety of mutual funds available means investors can find funds that meet their specific investment goals and risk tolerance. Unfortunately, market volatility affects mutual funds just like stocks or bonds. However, there a few ways to invest in mutual funds that minimize the effect of dramatic market fluctuations and protect your investment from volatility.

Highly Rated Bond Funds

Unlike stock funds, bond funds invest in debt securities that typically offer consistent interest payments each year and guarantee repayment of the initial investment upon maturity. Some bond funds that focus on generating the highest possible yields focus on buying and selling very high-risk bonds, called junk bonds, which offer the potential for quick gains but also carry a considerable risk of loss. Junk bonds are offered by companies or governments with extremely low credit ratings. The risk of default is high, so these bonds can be purchased for less than their face values. However, bond funds that invest in highly rated bonds issued by stable corporations or governments carry considerably less risk.

In a volatile market, investing in bond funds that only include debt securities issued by entities with high credit ratings is a great way to generate regular interest income with minimal risk to your initial capital investment. Because these companies and governments are unlikely to declare bankruptcy, the risk of default is virtually nonexistent. Bonds issued by the U.S. Treasury, specifically, are considered almost risk-free, regardless of market activity.

Money Market Funds

Money market funds are considered one of the safest mutual fund products available, even during periods of increased market volatility. Like bond funds, money market funds invest in debt securities rather than equity. However, unlike bond funds, money market funds invest only in highly rated, short-term debt. Assets in a money market portfolio are issued only by the most credible corporations, governments and municipalities, and have maturity dates less than one year away. Many money market funds invest in bills and notes issued by the U.S. Treasury, which are nearly risk-free, as referenced above.

Money market funds provide consistent growth in the form of annual interest payments. However, the trade-off for the increased stability of money market funds is a reduced rate of return; interest rates are often much lower than those offered by riskier funds. If you are looking to shield your capital from the ravages of unpredictable market fluctuations, money market funds can be an excellent option.

Long-Term Investments

Another strategy for protecting your mutual fund investment from a volatile market is to invest in funds that employ a buy-and-hold strategy. These funds invest in growth stocks or long-term bonds with the goal of creating long-term capital gains due to the increased value of their assets rather than short-term income generated by frequent trading.

Though a volatile market impacts the value of fund assets in the short term, especially stock investments, over time, the value of these funds tends to stabilize and may even benefit from price fluctuations during particularly volatile periods. This strategy is best for investors who do not need to withdraw their investments any time soon and are comfortable riding out the roller coaster ride of market volatility. Investors who are scared off by temporary value fluctuations may not be well suited to these types of funds.

Avoiding High-Yield Funds

Though the allure of increased investment income is undeniable, avoiding high-yield funds may be the best way to protect your investment from a volatile market. High-yield funds invest in high-risk bonds or highly volatile stocks, and utilize an extremely aggressive trading strategy to maximize short-term gains. In the case of high-yield bond investments, the risk of default by issuing entities increases if the entities suffer losses due to market volatility. In the case of high-yield stock assets, market volatility increases the odds of both profit and loss, meaning a high-yield stock fund may generate substantial gains but may also end up losing shareholder capital.

If your primary goal is to avoid the stress and fickle fluctuations of a volatile market, high-yield funds are not an appropriate investment. For those who are primarily focused on increasing investment growth regardless of the inherent loss potential, high-yield funds may be worth the risk.

Use Volatility to Your Advantage

Arbitrage funds are another option for those looking to avoid the increased risk of a volatile market but still wanting to benefit from dramatic price fluctuations. Arbitrage funds generate profit by simultaneously buying and selling the same investments at different prices. For example, a fund may purchase shares of ABC on the American market for $20 per share and sell the same number of shares on the London exchange for $20.15 per share. These funds make very small profits on each trade but execute hundreds of trades per year. Because arbitrage funds buy and sell securities simultaneously, they are considered relatively low risk, regardless of the current market climate.

Though arbitrage funds tend to carry higher expense ratios due to increased trade activity, they also tend to generate higher profits during periods of high volatility. This is because extreme volatility exacerbates the differential between stock prices on different exchanges or between prices on the cash and futures markets. For example, if ABC is currently valued at $20 but the market is extremely volatile, the same stock may be valued at $30 on the futures market because investors believe the stock price will increase rapidly.

Though no investment is absolutely risk-free, there are a number of ways you can invest in mutual funds that are less susceptible to market volatility. By choosing products that invest in highly stable assets or are specifically geared toward taking advantage of market fluctuations, you can use mutual funds to maintain an active investment portfolio while minimizing your overall risk level.

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