Low Risk Funds - Finding Low Risk Mutual Funds

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With the market as tough on investors as it's been in the last several years, it's good to take a look at ways to reduce the risk in your portfolio. Here we look at some non-traditional ways of lowering risk, with an emphasis on portfolio techniques that will work to find low risk mutual funds.

We'll find that it's not just finding low risk funds that's needed, but building a portfolio that has a low overall risk that we're after.

Portfolio Diversification

This is the time honored approach to managing risk in a portfolio, and if it's done right it will actually reduce risk. The problem with diversification is rooted in some of the basic assumptions. We've all heard the rule of thumb that you need 8 to 20 or however many stocks or mutual funds to build a truly diversified portfolio. However, the problem with that is the underlying assumption that the stocks or funds don't track one another, or to use the technical term, are uncorrelated.

But, as we've seen in the last couple of years, just having stocks that are from different industries, or different parts of the world, or even special sectors like health care and energy, which traditionally don't track the major market indices very well, is not much protection. We're seeing what is sometimes referred to as negative covariance. Basically, that means these sectors are not correlated when the market is trending up, but then tend to go down in unison. You can read more on this topic in the book the Intelligent Asset Allocator, or the reduced math version, the Four Pillars of Investing. Simple reading that explains how to really diversify your portfolio.

Market Timing

This is the tool almost everyone falls in love with at some point. The concept is simple, just get out of the market when it is going to go down, and get back in when it's going to go up. Extremely powerful stuff, and simple versions of it have a long track record. There's the old "Fabian 39 week moving average signal", there's the traditional "Sell in May and Go Away" rule, which works better than nothing, and there's even some record of just selling in the 3rd quarter since particularly August and September are not great months for the market, and October is infamous for 1987 and a couple of other particularly bad years.

There are a host of advisory services that claim to beat the market, and some may actually do it. Before you invest your money in any of these services, make sure you can see a copy of their actual trades, preferably verified by an independent third party. One of the best sources for tracking advisory service recommendations (they've been doing it for over 25 years) is the Hulbert Financial Digest. Don't invest a dime until you've seen the real track record, because this is much tougher to do than it seems.

Hedging

This is the technique that was the basis of the original, very conservative, hedge funds. While the hedge funds of today are more often than not using some ultra aggressive highly leveraged tools, the original hedge funds were designed to be very conservative by both buying stocks long and selling some of them short. The beauty of this approach is that the returns are relatively independent of the market's swings, and in fact, this technique is known as market neutral investing. The goal is to sell short funds that will be weaker than the overall market, and buy stocks that are relatively strong.

In the past, this required that you either use options to take both sides of the market, or actually short the stocks that you thought were weak. Neither of these can be done with mutual funds, and many tax sheltered vehicles like IRA's won't allow it if you wanted to do it. But in the last several years there are actually bear market funds that act like a short position in the market, that are traded like any other mutual fund, and can be bought in an IRA or other mutual fund brokerage account.

See the articles below for more information on low risk investing.

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