Risk tolerance refers to the level of volatility of an investment that an investor finds acceptable. The anticipated holding period of an investment is important because it should affect the investor’s risk tolerance. Time is a form of diversification; longer holding periods provide greater diversification across different market environments. Investors who anticipate longer holding periods can take on more risk.
The liquidity needs of an investor similarly help define the types of funds that the investor should consider. Liquidity implies preservation of capital, and if liquidity is important, then mutual funds with smaller variations in value should be considered. A liquid mutual fund is one in which withdrawals from the fund can be made at any time with a reasonable certainty that the per share value will not have dropped sharply. Highly volatile small-cap growth funds are the least liquid, and short-term bond funds are the most liquid. Table 1 lists the risk characteristics for different mutual fund categories.
Risk is the most difficult concept for many investors to grasp, and yet much of the mutual fund investment decision depends on an understanding of risk. There are many different ways to categorize investment risk and numerous approaches to the measurement of risk. If we can assume that the volatility of the return on your mutual fund investment is the concern you grapple with when you think of risk, the task of making decisions about risk becomes easier.