Mutual fund investment risks

Virtually all investments involve some level of risk. Risk is the chance that an investment’s actual return will be different than expected, and includes the possibility of losing some or all of the original investment.

Different types of risk are usually measured by calculating the standard deviation, a statistical measurement of volatility based on the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk.

A fundamental investment concept is the relationship between risk and return. The greater the amount of risk an investor is willing to assume, the greater the potential return. This is because investors need to be compensated for taking on additional risk.

Here are some of the risks you should discuss with your financial professional:

1. Inflation risk

When an investor buys a bond, he or she essentially commits to receiving a rate of return, either fixed or variable, for the duration of the bond or at least as long as it is held. But what happens if the cost of living and inflation increase dramatically and at a faster rate than the bond’s rate of return? When that happens, investors will see their purchasing power erode and may actually achieve a negative rate of return (again factoring in inflation).

2. Interest rate risk

Interest rates and bond prices carry an inverse relationship; as interest rates fall, the prices of bonds trading in the marketplace generally rise. Conversely, when interest rates rise, the prices of bonds tend to fall.

When interest rates are on the decline, investors try to capture, or lock in, the highest rates they can for as long as they can. To do this, they will buy up existing bonds that pay a higher rate of interest than the prevailing market rate. This increase in demand translates into an increase in bond price.

On the flip side, if the prevailing interest rate rises, investors naturally sell bonds that pay lower rates of interest, forcing bond prices down.

There are specific risks associated with international investing. Differences in accounting practices and potentially limited access to investment information may create challenges.

3. Credit risk

This is the risk of loss to the investor because the bond issuer fails to meet an obligation. Investors are compensated for credit risk through interest payments from the bond issuer.

4. International investing risks

International investing may expose investors to other risks, such as:

• Currency risk: The risk of the change in price of one currency against another
• Geopolitical risk: The risk that an investment’s returns could suffer as a result of political changes or instability in a country stemming from a changing government, legislative bodies, other foreign policy makers, or military control
• Liquidity risk: The risk that, due to a lack of marketability, an investment cannot be bought or sold quickly enough to prevent or minimize a loss