Ever paid attention to these lines of advertisements?
“Mutual funds investments are subject to market risk. Please read the offer document before investing “.
This disclaimer is mentioned in every advertisement of a mutual fund.
Risk is an inherent part of investing. Investments vary across the risk spectrum, but there is hardly any investment that’s entirely risk-free.
The best thing about investing in a mutual fund is that it provides you a wide scope of investment option/schemes depending on your risk appetite and your investment goal.
What’s even more fortunate is that investors can utilize various strategies to reduce the overall risk of their mutual fund portfolio.
In this article, I will discuss various risks associated with mutual funds. These strategies are designed to minimize your mutual fund portfolio risks no matter how uncertain the market conditions are.
In this article
- Risks associated with Mutual Funds
- Strategies to minimize mutual fund risks
Risks associated with Mutual Funds
The level of risk in a mutual fund depends on which investment instrument is picked by a mutual fund manager. Generally, a higher risk investment fetches you higher returns.
Below are a few types of risks that are inherent in any mutual fund scheme:
|Type of risk||Mutual fund type||Risk associated|
|Market risk||All types||The value of its investments declines because of unavoidable risks that affect the entire stock market|
|Liquidity risk||All types||The risk of lack of market to sell funds, when you want to exit.|
|Credit risk||Debt mutual fund||The risk of default by the fund house or borrower. They are supposed to invest in debt fund that are rated high on investment grade by credit ratings agencies. But sometimes fund houses invest in lower rated debt papers than the safest paper in the market.|
|Interest rate risk||Debt mutual fund||The risk due to change in interest rate, where your fund manager takes wrong call on interest rates.|
|Country risk||All types||The value of a foreign investment declines because of political changes or instability in the country where the investment was issued.|
All mutual funds carry a riskometer which shows the level of risk inherent in a fund, in a particular category. Both equity and debt mutual funds carry risk. However, risk associated with debt funds is less than that of equity funds.
Strategies to minimize mutual fund risks
Risk is something which needs management not avoidance.
The overall risk in mutual funds can be minimized following these easy strategies:
1. Portfolio Diversification
As an investor, you should always look to diversify your portfolio and limit your exposure to a specific type of investment.
You can achieve diversification of your mutual fund portfolio through two processes – different types of mutual funds across fund houses and different subcategories of each type of scheme.
There are 3 major categories of mutual fund types, equity, debt and hybrid funds:
|Debt||Risk is lowest when you choose to invest in debt funds|
|Equity||Risk gradually increases as you shift towards equity funds|
|Hybrid||These funds have moderate risk|
Additionally, in case of equity investments, further options include large-cap equity funds, mid/small cap equity funds, value/contra equity schemes, sectoral funds and tax saver ELSS mutual funds.
Similarly in case of debt funds available options include ultra short-term funds, liquid funds, gilt funds etc.
The top choices available to an investor of hybrid funds include balanced funds, arbitrage funds, equity-oriented hybrid funds and debt-oriented hybrid funds.
Each of these sub-categories invests in different types of equity or debt instruments hence they feature markedly different levels of risk.
Through diversification, the individual risk of each type of investment or exposure to a particular type of investment can be minimized by the investor.
2. Investing with an expectation of very high return
In case you are new to mutual funds, you might make the classic beginners’ mistake and invest in a fund that has offered the highest returns in the previous year.
More often than not, these choices would include small or mid cap mutual funds that offer the highest returns.
However, these mutual fund schemes are considered to be among the riskiest investment options currently available to Indian investors, at least in part.
So, instead of investing in such schemes that have higher exposure to a specific sector/theme, you would be better served to invest in multi cap equity schemes or large cap mutual funds.
3. Invest through SIP
Systematic Investment Plan(SIP) is a method of investing money in mutual funds. The other way to invest is lump sum or one time payment.
In an SIP, instead of lump sum the investment is done regularly on specific intervals either weekly or monthly or quarterly.
Here you will divide your planned lump sum investment into 12 equal parts, say if you plan to invest ₹1,20,000 in March, as a lump sum, in an SIP you will invest ₹10,000 per month.
SIP is an instrument which helps you avoid the risk of timing the markets and facilitates wealth creation in a disciplined manner by averaging cost of Investments. Small savings create the big corpus for future.
So, to save yourself from the stress, you should always opt for an SIP to invest in mutual funds, especially for equity oriented funds.
However, SIP is not the only systematic plan available to an investor.
In case you already have investments that you need to reinvest systematically, you can choose to utilise STP i.e. the systematic transfer plan
STP helps you to transfer a fixed amount from a particular mutual fund scheme (usually a debt fund) to another (usually an equity oriented scheme) within the same fund house. When you are setting up an STP, you are actually instructing the fund house to sell a part of your investment in a debt fund and invest the money in another scheme.
The basic idea behind an STP is to earn a little more on the lump sum amount while it is being deployed in equity-oriented schemes. Debt funds excel over the normal savings bank account in terms of return on your investments.
The other option in case of systematic plans is the SWP or systematic withdrawal plan.
Just as the SIP strategy eliminates the need to time your entry into the market, the SWP strategy eliminates the need to time your exit or redemption.
Using the SWP strategy you can redeem/liquidate existing investments bit by bit and get the money deposited automatically into your registered bank account.
4. Understanding your risk tolerance
One of the biggest obstacles faced by mutual fund investors, is a poor understanding of their risk tolerance.
The simplest definition of risk tolerance is a determination of how much risk you are willing to take, with respect to your investments including risk to the principal amount invested.
In common practice, younger individuals who have fewer family responsibilities are more risk tolerant as compared to individuals who have greater family obligations or are closer to retirement age.
You should tailor your investment portfolio depending upon the level of risk tolerance that is acceptable to you.
For example, equities are classic high risk – high returns investments, while debt investments on average have a lower level of risk while featuring relatively lower returns.
5. Beware of “low” NAV and NFOs
Some investors believe lower the NAV (Net Asset Value) of a fund, the better value it provides.
In other words, a fund with an NAV of ₹30 is ”cheaper” than another with an NAV of ₹50. This is a mistaken belief applied by many investors.
So, often such investors, invest into a New Fund Offering (NFO) at par value or ₹10, thinking they are buying value.
In fact many brokers sell NFOs to investors especially new investors by saying things like – “it has a low NAV and is thus cheaper than other fund units”, “you can easily sell at a higher price soon after launch and make a profit”, etc.
But as you already know, that it makes no difference whether the NAV of a fund is high or low.
In fact, older funds, with a longer track record, will always have high NAV and you are better off choosing those rather than a new fund with lower NAV but no track record.
Thus in case you have only recently started investing in mutual funds, it might be better for you to shy away from NFOs at least till you have created an adequately diversified portfolio.
6. Avoid herd mentality
It’s true that emotions and not logic rules the average investor’s decision making. History suggests that large groups can be wrong but we refuse to believe it.
A typical investor’s decision is usually influenced heavily by the actions of his relatives and acquaintances.
When markets rise continuously, a majority of investors speculate that it will reach further highs and they continue to increase in investment.
However, this rise is often not sustainable and inevitably a market correction follows, which rationalizes the prices of overvalued stocks.
Another herd mentality keeps you out of market bottoms. Herd mentality prevents you from buying at the bottom as panic is there in the market and most of the investors are stating that market will crash more.
So, do not follow the herd blindly when making mutual fund investments, instead research the prospective fund before you sign up for an SIP plan or make lump sum investments in such a scheme.
7. Ensure Adequate Liquidity
A major concern that many new investors ignore is liquidity.
Liquidity is a feature that allows an investment to be redeemed with ease for a fair price within a predetermined period of time.
The higher the liquidity of a scheme, the easier it is to redeem in case of an emergency.
Equity-oriented mutual funds are considered to be some of the most illiquid investments around as some of them (ELSS) comes with fixed tenure and most of them come with an exit load for a year.
Thus, it is important for you to consider maintaining a balance between liquid and illiquid investments so that you have sufficient liquidity in order to meet any and all emergency expenses that might occur in the future.
Liquid mutual funds, as the name suggests, are those funds in which the investments in a particular financial instrument can be easily withdrawn, to get immediate cash.
These are types of debt mutual funds that invest in debt securities and money market securities with maturity of up to 91 days only.
You should always remember that being market-linked investments mutual fund returns will fluctuate depending upon prevailing market conditions.
Thus, you need to have realistic expectations and even though the probability of out performance is high in case of mutual funds as compared to fixed rate investments, such returns will definitely not be constant especially in the short-term.
However, it is important to note that even holding cash in physical form is risky as it involves risk of theft, inflation, etc.
Mutual Funds help you maintain a balance between taking suitable level of risk and generating desired level of return.
Investing in mutual funds online is very simple and paperless. Simply log in to your Groww account, choose a fund, and invest using net banking – exactly like you would when shopping online.
Start investing in mutual fund early and stay invested for longer duration to get its true benefit. Here are the top 10 mutual fund for you to bet in 2019, check out Best mutual funds to invest in 2019.
Disclaimer: The views expressed in this post are that of the author and not those of Groww