Compare fund risks, returns

All mutual funds contain a measure of risk. The question is how much you’re prepared to accept. The more risk you take, the higher your potential returns should be, and vice-versa. Volatility is a good measure of risk, but it can be misleading at times.

If you’re going to invest money in mutual funds, you have to accept a degree of risk. If you can’t accept that, then keep your money in a savings account — although I have to tell you even that’s not entirely risk-free.

But the mutual fund risk scale is very wide, ranging from minuscule to very high. You can pick any point on it that you like.

If you want to keep risk to an absolute minimum, you can concentrate your mutual fund investments in money market funds and mortgage funds. No money market fund sold in Canada has ever lost money for investors (although it could theoretically happen in certain extreme circumstances).

Some mortgage funds may occasionally decline in value, but there are some that have never lost a dime in any calendar year since they were created — in some cases, that covers a span of more than two decades.

As a general rule, the reality is that the less risk you take, the lower your potential returns. If you want above-average profits from your funds, then you’ll have to crank up the risk level a few notches. It goes with the territory.

Clearly, the risk/reward relationship must be a key consideration when you decide which mutual funds to buy. If preserving capital and avoiding loss is your prime concern, you’ll select a conservative fund that shares these objectives. In this case, you’ll give up some potential return for a higher measure of safety.

On the other hand, if your objective is to maximize growth and you’re willing to incur greater risk to achieve this, you’ll search out more aggressively managed funds — and there are plenty around.

Balanced

Medium

Medium

Dividend

Medium

Medium

Real Estate

Medium/High

Medium

International equity (Broad-based)

Medium

Medium/High

U.S. Equity (Broad-based)

Medium/High

Medium/High

Canadian equity (Broad-based)

Medium/High

Medium/High

Regional

High

High

Emerging markets

High

High

Small cap

High

High

Sector

High

High

You can determine a specific fund’s risk potential through the use of a more precise measure known as "volatility" (also called "variability"). Volatility is a mathematical calculation that measures the extent to which the actual monthly returns for a given fund swing up or down from its average return over a given period of time (usually three years).

• Suppose a fund has an average rate of return of 1 percent a month over five years. That average could have been achieved through a series of sharp ups and downs — a gain of 10 percent one month, a loss of 8 percent the next, a jump of 5 percent the next and so on. In that situation, the fund would be said to have a high volatility rating and the risk factor would be significant.

However, if the actual returns throughout the whole period were exactly 1 percent each month — no movement up or down — the fund would have a volatility rating of one (or 0.1 or zero, depending on the scale being used). This implies a very conservative management strategy and a correspondingly low risk rating.

The concept of volatility is useful, but it must be combined with a little common sense. For example, most money market funds have volatility ratings of one. That’s because of the low-risk nature of their investments—treasury bills, term deposits and high-quality short-term corporate notes.

An investment portfolio of this type is as close to risk-free as you’ll find and churns out consistent returns month after month. Since volatility scores put a premium on such virtues, money market funds score highly.

If volatility were the only criterion applied, everyone would have all their cash in money market funds. However, there are other things to consider.