Avoiding Risk of Funds Can in Itself Be Risky Business : Finance: Analysts say many investors play it too safe, avoiding dangers--and often higher returns.

NEW YORK —  As American investors try to educate themselves about the ins and outs of mutual funds, much of their confusion focuses on the word “risk.”

Every time they are surveyed, would-be fund buyers seem to testify that they simply don’t understand the basic risks involved.

On the other hand, once they are aware of hazards, they often appear determined to avoid them at all costs--as if investment success were simply a matter of eliminating risk from the process.

One center of activity in the battle over risk has been the nation’s bank branches, where products like mutual funds and annuities are now marketed alongside traditional vehicles such as certificates of deposit that are covered by federal deposit insurance.

By all the evidence, bank customers are hazy, at best, on which of the merchandise is federally insured and which isn’t.

“We see a distressing pattern of confusion and false comfort on the part of bank customers, a very substantial portion of whom do not seem to grasp that banks are no longer just in the business of selling FDIC-insured products,” says Craig Goettsch, an Iowa securities regulator and president of the North American Securities Administrators Assn.

“When the next market correction takes place, millions of U.S. consumers could learn the hard way that there is no safety net for mutual funds and stocks sold at banks.”

At the same time, however, many analysts argue that the typical fund investor plays it too cautiously.

They note that of the $2 trillion in funds of all types, close to $600 million, or nearly 30%, is in money-market funds yielding an average of 2.75%.

That compares to total returns for 1993 of close to 10% or more for almost all categories of stock and bond funds.

Those longer-term funds are riskier than money funds--at least in the sense that they are subject to fluctuations in net asset value, which normally don’t occur in money funds.

Of course, if the market climate turns sour in 1994 or at any other future time, long-term funds could show negative results for a spell that would make whatever return money funds were earning look great by comparison.

But the risk of a market “correction” may be worth taking, if you understand it and can afford to ride it out. As financial professionals are quick to point out, trying to avoid risk may have even greater costs.

For instance, many fund managers lament that they see their customers shunning short-term bond funds that return, say, 5.5% and sticking with money funds at 2.75%, even though the difference in risk is nowhere near double.

Standard & Poor’s Corp., which has just launched an effort to rate bond funds for all their various risks, offers this advice: “Don’t automatically choose the bond funds with the lowest risk. Funds with the lowest risk generally earn the lowest long-term returns.

“In general, investors must accept some risk to earn greater long-term returns. That means investing in funds with longer maturities, lower credit quality and other types of investment risk.

“You must determine for yourself how much risk you can accept, based on your individual goals and time horizon.”

Some risks are simple to quantify. For instance, a few moments with a calculator may be all it takes to determine how much the net asset value of a government bond fund will decline if interest rates rise by one percentage point.

Others are less precise. Nobody knows for sure how far a good stock fund might decline in a bear market, or how long it might stay down.

But whatever form they take, risks in mutual funds need to be acknowledged and studied. There is not much promise in either denying those risks or just deploring their existence.