Before getting into the world of mutual funds, understanding the associated risks is crucial for investors to make informed decisions. Mutual funds offer potential for growth, but they also come with various risks that investors should be aware of. From market volatility to specific risks related to the fund’s objectives and strategies, navigating these risks is essential for maximising returns and managing potential losses. In this guide, we will explore the different types of risks associated with mutual funds, equipping investors with the knowledge they need to navigate the complexities of the investment landscape confidently.
Table of Contents
Defining Mutual Funds
Mutual funds are investment vehicles that pool money from multiple investors to invest in a diversified portfolio of securities such as stocks, bonds, money market instruments, and other assets.
- These funds are managed by professional portfolio managers who make investment decisions on behalf of the investors.
- Investors in mutual funds own shares of the fund, which represent their proportional ownership of the portfolio’s assets.
- Mutual funds offer individual investors access to professionally managed portfolios, diversification, liquidity, and the opportunity to participate in various financial markets with relatively small investments.
Risks Associated With Mutual Funds
Investing in a mutual fund scheme does not guarantee or assure returns, as it is subject to various risks. These risks include trading volumes, settlement risks, liquidity risks, default risks, and the possibility of principal loss. Mutual funds invest in a range of instruments such as debt, equity, and corporate bonds, which can lead to potential losses due to price fluctuations influenced by various factors. The Net Asset Value (NAV) of these investments may decline, resulting in losses for investors. However, investors can navigate the risk-reward structure of mutual funds by understanding and identifying the risks associated with them before making investments.
Types of Risk
Risks Associated With Equity Investments
- Volatility Risk: Typically, equity-based funds invest in stocks of publicly traded companies. These funds are valued based on companies’ performance, which is often affected by microeconomic factors. Government directives, SEBI regulations, the economic cycle, RBI policies, etc., are some of these factors. Thus, the stock price is influenced by these factors, which may increase or decrease its value.
- Liquidity Risk: There is often a liquidity risk associated with mutual funds with a long term and rigid lock-in period like ELSS. Often, investors find it difficult to redeem their investments without incurring a loss due to such a risk. In the case of ELSS, investors cannot do anything with their investments during a rigid lock-in period. Furthermore, investors often find it difficult to redeem investments at a time that is convenient for them due to a lack of buyers on the market.
- Risk of Losing Money: If investors are not comfortable with the risk of possible loss of principal, they should not invest in equity schemes.
- Event Risk: There is a price risk associated with an event specific to a company or sector.
Risks Associated With Debt
- Interest Risk: The risk of interest fluctuation in mutual fund investments haunts investors throughout the investment horizon. In most cases, it arises from uncertainty regarding the capital an investor will obtain at the end of the investment period. Thus, if the interest rate changes, so will the price of the debt instrument. If the rate of interest increases, then the price of bonds will decrease, and so will their value.
- Credit Risk: Investing in mutual funds can carry credit risk if the issuer of the scheme fails to pay interest as promised. A debt fund’s manager typically includes investment-grade securities with high credit ratings. Nevertheless, the fund manager includes lower credit-rated securities to increase returns. A move like this often increases the risk of not being paid on time.
- Inflation Risk: Inflation is the risk of losing one’s purchasing power, primarily due to the rising inflation rate. When investment returns fail to keep pace with increasing inflationary rates, investors are exposed to this risk. Suppose the rate of return is 5% and inflation is 3%; then investors receive only 2%.
- Concentration Risk: Investments in mutual funds are also subject to this risk. This is a situation when investors invest all their funds in a single investment scheme or sector. In bad market conditions, investing entirely in just one company’s stocks can lead to a substantial loss of capital.
- Currency Risk: This risk is caused by the fear that a decrease in the exchange rate will decrease investment returns. A decrease in foreign currency is believed to occur when the value of foreign currency-denominated funds increases. In INR terms, it will directly lower the rate of return.
- Rebalancing Risk: Investing in mutual funds involves frequent rebalancing by fund managers and close monitoring by the fund managers. It is common for regular reinvestments to be accompanied by a risk of not taking advantage of growth opportunities. Despite mutual fund risks, by planning smartly, one can mitigate them.
Best Ways to Combat Mutual Fund Risks
Assess Risk Appetite and Build a Portfolio Accordingly
- Match investment profiles with risk tolerance to mitigate mutual fund risks.
- Consider factors like age, financial status, risk appetite, and financial goals.
- Those with low-risk appetite and long term goals may find balanced portfolios of debt and equity suitable.
Plan Investments According to a Systematic Approach
- Distribute risk burdens significantly through systematic investment planning.
- Utilise Rupee cost averaging and compounding to reduce the average cost of investment.
Invest Through Systematic Transfer Plan (STP)
- Spread risk associated with mutual fund investments over time.
- Lower the average cost of investment and reduce the impact of entering overvalued markets.
- Switch between funds to consolidate gains and reduce associated risks.
Diversify Portfolio
- Allocate investments between asset classes and sectors to balance risk-reward ratios.
- Consider risk appetite, time horizon, and financial goals when diversifying.
- For short term goals, opt for debt schemes for capital protection and guaranteed returns.
- For long term goals, consider equity mutual funds for their high risk-reward ratio.
Conclusion
A mutual fund can provide long term wealth growth. Nonetheless, every investment journey comes with its own risks. Investments in mutual funds also include a variety of risks since they contain both equity and debt investments. It is essential to understand mutual fund risks to make informed financial decisions. Market volatility, liquidity challenges, and interest rate fluctuations all require careful consideration. The team of Share India can assist with these complexities, enabling investors to make informed decisions. With Share India, one can navigate risks, diversify wisely, and secure their financial future.
