Before investing in a mutual fund the prospective investor should first identify how much risk he or she can tolerate. This will help the investors choose a fund they will be comfortable with. A popular way to find out risk tolerance is to answer a series of questions. Mutual fund companies ask potential investors to complete a short questionnaire. Risk tolerance is identified according to the answers given. Similar questionnaires are also available on the Internet. The questions are about what kind of returns an investor wants or expects, the investment time frame, what losses the investor can tolerate, among others.
In my experience I've found that the results of these tests are only a good first approximation. There are other factors that affect investors attitude towards risk aside from investment philosophy. Changing personal and financial circumstances, increasing financial experience and knowledge, and age are all contributing factors. When I started investing in mutual funds this year I chose to invest in equity funds. I assessed myself to have high tolerance for risk. The recent stock market performance has tested that assessment. From the recent record highs the market index has dropped significantly, and bounced back again. It's an early and easy test, but it's made me reevaluate my risk tolerance.
Right now I'm sticking to equity funds but I'm also seriously considering moving to balanced funds. I don't want to act too hastily so I'll be in wait-and-see mode for now. Does this invalidate risk tolerance questionnaires? No, but it did teach me that you have to put a lot of thought into your answers to get a more accurate result, and that investor attitudes can change in a relatively short time frame.
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