Advanced Diploma of Financial Planning (ADFP) Practice Test

What should investors be aware of regarding risks in mutual funds?

1. They don’t need to understand the risks

2. They need to understand the risks inherent in underlying securities

3. All mutual funds are risk-free

4. Only high-risk funds involve substantial risks

The correct answer is: They need to understand the risks inherent in underlying securities

Investors in mutual funds should be particularly aware of the risks inherent in the underlying securities because mutual funds are essentially a pool of investments. Each fund typically holds a variety of assets, such as stocks, bonds, or other securities, which carry their own particular risk profiles. Understanding the risks associated with these individual investments provides insight into the overall risk of the mutual fund itself. For example, if a mutual fund predominantly invests in high-tech stocks, it is likely to be more volatile and subject to greater fluctuations compared to a fund invested in government bonds. By grasping these underlying risks, investors can make informed decisions that align with their risk tolerance and investment goals. The other options present misleading perspectives: suggesting that investors don’t need to understand risks overlooks the importance of informed investment decisions; stating that all mutual funds are risk-free is inaccurate, as all investments carry some level of risk; and implying that only high-risk funds involve substantial risks fails to recognize that even conservative funds can experience significant declines in certain market conditions. Thus, understanding the risks in the underlying securities is crucial for effective mutual fund investing.