Achieving the higher returns from investing in the stock market carries with it also the higher risk that something will happen to the principle invested. Concerns that the stock market will dip or that a particular company invested in will go bankrupt or have a bad news report is what is worrisome to most investors. One way to use risk management on reducing this risk is to invest in several different mutual funds.

There are constraints that need to be taken when deciding which mutual funds to invest in. One of these is the cost of the mutual fund. Mutual funds carry with them what is called load fees or exit fees. This is so the expenses of the mutual fund can be handled. An investor needs to review the fees and ensure they are getting the most for their money.

Another thing an investor needs to look at is what stocks the mutual fund is invested in. Often times an investor will invest in 2 – 3 mutual funds and have not really diversified as well as they could due to the fact that the mutual funds they have selected have invested in the same stocks or similar stocks. This results in over diversification. A review of the top holdings is necessary before making a purchase decision.

A well diversified portfolio includes asset classes that are not highly correlated and thus are considered to be complimentary. By spreading your investments over several different funds that have low correlation to each other, the price fluctuations are greatly reduced. This is due to the fact that not all industries move up and down at the same time. Choosing industries that move counter to each other will greatly reduce your risk.

Stock correlations range between +1.0 and -1.0. If an evaluation of two stock funds shows they have a correlation of .93, if you invest in these two funds, you are in essence investing in just one fund since they tend to move together. A better scenario would be to invest in funds that have a correlation of -.25. This would better diversify your portfolio.

The determination of correlation uses a regression analysis which in essence plots the returns and risk for each fund on a graph and determines how they move in relation to each other. The math behind the analysis is a little complicated. There are correlation calculators available on the internet that will simplify this math. By plugging in the funds, you can find out how they correlate to each other.

Another method to use to reduce your risk is to invest globally. A study completed by the Indiana University of Pennsylvania as reported in the Encyclopedia Britannica found that “portfolios with only forty stocks spread among major domestic and international markets reduce risk of domestic portfolios by more than 50 percent”. In this study the European markets were found to be more correlated with the domestic markets while the Asian markets were less correlated and the emerging markets were the least correlated. Thus a portfolio which invests in funds that cover domestic as well as foreign and emerging markets will reduce your risk.

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