How do mutual funds help in reducing the risks of investment?

Investing is incomplete without diversification. Without it, an investment portfolio suffers from unwarranted risks that can reduce the Return on Investment (ROI). When you are investing capital, always remember to select an array of different sectors, and asset types to minimize the risk.

What are the different risk types?

Throughout their career, financial advisors and investors experience two different types of risks.

1. Undiversifiable

It is the market risk or the systematic risk that is a niche to every company. Exchange rates, inflation rates, war, political reforms and instability, and interest rates influence the systematic risk of any investment. An undiversifiable risk is not unique to a particular industry or company. There is no way to reduce it via diversification. Every investor and RIA have to accept this risk before investing.

2. Diversifiable

It is the unsystematic risk that one can reduce by allocating their capital to different assets, and industries. Since it is specific to a particular company, market, sector, country, and economy, careful research and smart investment tactics can reduce the risk to a significant degree. Financial risk and business risk are the two most common sources of unsystematic or diversifiable risk.

Diversification reduces the risks of investment. According to the Innovative Portfolios for financial advisors, it can avert the financial disaster that can result from an economic slump or a failure in one sector or asset group. It allows the investors to spread the risk out across multiple assets, stocks, cash, and bonds.

Mutual funds can help you diversify your investment portfolio

Mutual funds bring forth the advantages of diversification. It helps in instant diversification of funds, and the diversification of the portfolio in multiple fund categories. One of the most significant benefits of mutual funds is that you can gain access to a diversified portfolio by investing a few thousand dollars in a single fun. It is so simple that any new investor can manage several mutual fund investments at one go without the intervention of an RIA. Most importantly, mutual funds also allow the diversification of the investment into several sectors, styles, countries and other security types you can imagine.

How to diversify through mutual funds?

Mutual funds are effective instruments of diversification. However, do not make the mistake of believing that investing in different mutual funds is the same as diversifying. For example – you might select two different mutual funds, but it will do you no good if they have the same holdings for good time. You cannot consider this as diversifying since the factors the effect the securities in one fund will also affect the other.

To diversify, you must pick a fund that has little to no common holdings with the other mutual funds you have selected. Try to spread the capital across a variety of mutual fund categories. This process will help you reduce the risk to one particular sector or stock. It can also open the path for potential rewards through broader exposure to multiple industries and stocks.