How to Tell the Risk Level (Potential of Loss) of a Mutual Fund
There are several ways to tell the risk level of a mutual fund. However, there is one way that I find is a good global look at risk. Of course, this isn't a slam dunk risk measurement all of the time (nothing is). It has been enough of the time to be deemed effective. I use it myself with my own money management. It is very easy to understand. It is called Beta. I went into detail on this webinar. A Beta of 1 means you are taking the same risk of the market. For example, let's say the Beta of the fund is 1, then the mutual fund risk level is the same as the index (type of fund or stock market index) is taking. Thus, theoretically, if the index were to go down 50%, the mutual fund would be expected to go down roughly the same (See disclaimer). If the Beta is .5, it is taking 1/2 of the risk. If the Beta is greater than 1, the mutual fund is taking more risk than the index.
So, if you are looking for a low risk mutual fund, you are looking for a mutual fund with a lower Beta. I use this tool when evaluating loss potential of a mutual fund portfolio in a declining market. How vulnerable will my client's money be to loss when the market declines? If I were wanting to take higher beta risk, I would simply use an index fund and track the stock market.
Why is this important?
With this knowledge, you can ask your financial advisor what the Beta is of your portfolio. If you have a lower risk level and the Beta of the portfolio is 1 or near 1, then you might want to ask some questions. You can also ask your 401 K provider this question. This will allow you to adjust risk level accordingly.
Most importantly, mutual funds with betas lower than .5 generally lose less in market downturns and make up those losses much quicker than the market itself (see disclaimer). A few keys to long-term success with investing is understanding the risk level you are taking, understanding your exposure to loss, and understanding how long it might take you to make up that loss. With the answers to those questions, you can determine if you are comfortable with the level of risk you are taking.
DISCLAIMER - This is intended to give you a general overview of risk or Beta. There are many other specific details not covered. This however will enable you to ask questions and identify red flags. Just because a lower beta fund lost less in the past and made it up quicker than the market does not mean it is guaranteed to repeat that process. The lower beta of .5 was used as an example and not to mean that all lower beta funds of .5 or lower will perform the same way. This is meant for educational purposes only and not as a specific recommendation.