Market Risks in Mutual Funds - BlueCollarDollar.com

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Market Risks

We'll call this discussion "sleeping with the bulls and the bears". In our continuing review of risk in mutual funds, you will come to the realization that there is no perfect market, no perfect time to buy and no perfect time to sell. But there are some things you can do to help find near-perfect investment environments and brave the bitter cold or intolerable heat that market risk can provide.

In other words, you need to understand that you are "market risk".

That problem poses two questions: what is rational behavior and do markets (which are, as we have found out, not all that rational) react the way they do based on sound logic?

Rational behavior is the harder of the two to answer. A recent column by New York columnist David Brooks suggest that "Markets tend toward efficiency. People respond in pretty straightforward ways to incentives. The invisible hand forms a spontaneous, dynamic order. Economic behavior can be accurately predicted through elegant models." Only, as he points out, not this time. And possibly not ever.

He is correct in pointing out that our minds are a mess of chaotic impulses and desires that are pushed forward and, as he says vie for supremacy, the instincts fighting the strategies while the intuitions, we claim to own battle with our emotions as memories try to run roughshod over our habits. And with this confusion constantly at play and the markets, living and breathing entities themselves, also in possession of the same collection of idiosyncratic impulses. its no wonder we can make little sense of where we are going or how to even get there.

He goes on to explain the habit we have of selective data processing. If some tidbit of information makes us feel better, we go with it. Red wine is good for you so therefore, a lot of red wine might be better. Mr. Brooks spoke with Andrew Lo of M.I.T. who "has demonstrated, if stock traders make a series of apparently good picks, the dopamine released into their brains creates a stupor that causes them to underperceive danger ahead."

Each downturn or bear market has its own personality, its reason for being. Yet all bull markets are identical. They all run on investor dopamine, strangling out good sense over caution. Mutual fund managers, at least those that live and breath like the shareholders they represent, are subject to the same reactions as you. With any luck, the upside euphoria will be muted (but not likely) and the downside will be more measured (but like us, they panic as well).

Market risk offer us a unique opportunity to participate and grow our money. But the sting it can deliver can be quite painful and unexpected. Embracing risk in the markets requires two distinct things: dollar cost averaging (even and measured investing over a long period of time) and patience (that once the bad goes away, we will have five times as much good as there was bad).

Next up: regulatory risk