How Risky are Your Mutual Funds?
Ron DeLegge, Editor
October 12, 2009

SAN DIEGO (ETFguide.com) – The stock market has boomeranged from its March lows and some are convinced the sky is the limit. But do you know how much risk your mutual funds are really taking with your money?

A recent survey conducted by Charles Schwab is telling about just how little fund investors really understand about their mutual funds.

The study found that just 4 out of 10 mutual fund investors surveyed have made changes to their portfolio allocations since the stock market began to decline. Less than half (45%) of those surveyed have become more knowledgeable about their investments since the financial crisis began roughly two years ago.

Get to Know Your Fund
Successful investors know and understand what they own. Ask yourself; How familiar are you with your mutual funds? What do they invest in? Your fund’s quarterly and semi-annual reports along with the prospectus usually contain this important data. 

Look at your fund’s top ten holdings. Is the fund over-concentrated in one particular stock or industry sector? If it is, it could indicate that your fund’s manager is making big bets which may not necessarily pay off.

Analyze your fund’s cash balance. Is the fund manager fully invested or do they have a large cash balance? A large cash position might indicate your fund’s manager is attempting to time the market. Few professionals and even fewer amateur investors can successfully time the market with 100% accuracy.

Here’s one other question to ask: Does your mutual fund invest the same exact way as it’s described? If you own a growth fund, for example, your fund should not own value stocks. Likewise, a small cap fund has no business owning large cap stocks and domestic stock funds should not own international stocks.

Risk Adjusted Performance
It’s been said there’s only two reasons active managers will ever outperform their benchmark index; One, because they got lucky and two, because they took more risk. Recent investment studies confirm this undying truth.

Over the past three years, Morningstar found that just 37% of actively managed mutual funds outperformed their corresponding indexes on a risk adjusted basis. And here's what it means to you: Even though some mutual funds may have beaten their benchmarks in absolute terms, they frequently expose their investors to higher risk, nullifying the results.

How have your mutual funds really performed on a risk-adjusted basis versus their corresponding indexes?

Build on the Right Foundation
How many mutual fund investors have overemphasized their fund manager’s ability to choose the right stocks? And how many fund managers still consistently fail to beat brainless indexes like the S&P 500 (NYSEArca: SPY), S&P MidCap 400 (NYSEArca: MDY) and the S&P SmallCap 600 (NYSEArca: IJR)? By focusing too much on stock picking ability, fund investors make a fundamental mistake by underestimating the role of their asset mix or allocation on their bottom line.

The best asset allocation plan in the world is effortlessly undermined by fund managers that deviate from their investment mandates through nonsense activities like hyper-trading and style-drifting. The simplest way to avoid these unquantifiable risks is to make low cost index funds or index ETFs the foundation of your investment portfolio.

Conclusion
You should know and understand what type of risk your mutual funds have. You should also take steps to limit your risk and increase your odds of long-term success.

One way to accomplish this vital mission is to first own index funds in an appropriate mix that best matches your financial objectives and investment time horizon. This should be the first priority for your serious money.

And finally, any extra money that’s left over can be used to invest in active funds, individual stocks or whatever other crazy ideas come to your mind.