Investments are always accompanied by some risks. For instance, an investment tool like mutual funds offers benefits like value-for-money and diversification to investors but still bears some associated risks. The best an investor can do to minimise mutual fund risks is to learn more about them and practice ways to cushion the same.
In this article
What Makes Mutual Funds Risky?
The fundamental reason which makes mutual fund investments risky lies in the fact that it puts money in a variety of investment instruments – debt, equity and corporate bonds, among others. Since the prices of these investment instruments tend to fluctuate in response to several factors, investors may be subjected to loss.
It mainly happens because of the fall in the NAV of these investments. However, mutual fund investors can make the most of the risk-reward arrangement of the investment tool by identifying the risk involved in mutual funds beforehand.
Types of Risk in Mutual Funds
In a broader sense, mutual fund risk can be categorised as – systematic risk and unsystematic risk. Here is a list of risks associated with mutual funds investment.
Risks involved with equity mutual funds
- Volatility Risk
Typically, equity-based funds invest in the shares of companies that are listed on stock exchanges. The value of such funds is based on companies’ performance, which often gets affected due to the prevalent microeconomic factors.
Such factors include – a change in government directives, SEBI regulations, economic cycle, RBI policies, etc. Notably, these factors influence the stock price and may either increase or decrease the share value.
- Liquidity Risk
Mutual funds with a long-term and rigid lock-in period like ELSS often come with liquidity risk. Such a risk signifies that investors often find it challenging to redeem their investments without incurring a loss.
For instance, ELSS comes with a rigid lock-in-period during which investors cannot do much with their investment. Furthermore, often lack of buyers in the market makes it challenging to redeem investments at a time considered suitable by investors.
Risks involved with debt mutual funds
- Interest risk
Interest risk in mutual fund investment manifests in the form of varying interest value and haunts investors throughout the investment horizon. It is mostly rooted in the uncertainties pertaining to the capital an investor is likely to avail at the end of the investment horizon.
In other words, if the interest rate changes, the price of the debt instrument will also change. For instance, when the rate of interest increases the price of bonds decreases and in turn, the value of bonds also decreases.
- Credit risk
Credit risk in mutual fund investment often results from a situation, wherein, the issuer of the scheme fails to pay the promised interest. In case of debt funds, typically, fund managers include investment-grade securities with high credit ratings.
However, to enhance the rate of returns, the fund manager includes lower credit-rated securities. Such a move often increases the risk of not getting paid as promised.
- Inflation Risk
It can be best described as the risk of losing one’s purchasing power, mainly due to the rising inflation rate. Typically, investors are exposed to the impact of this risk when the rate of returns earned on investments fails to keep up with the increasing inflationary rate. For instance, if the rate of returns is 5% and the rate of inflation is 3%, then investors are left with only 2% returns.
- Concentration risk
This mutual fund risk is also prevalent among investors. It can be described as the situation when investors tend to put all their money into a single investment scheme or in one sector. For instance, investing entirely in just one company’s stocks often bears a substantial risk of losing capital if caught amidst bad market situations.
- Currency Risk
The said risk pertains to the fear that a decrease in the exchange rate will decrease the investment returns. To elaborate, it is believed that when the value of foreign currency-denominated funds increases, it will result in a decrease in foreign currency. It will directly lower the rate of returns when exchanged into INR.
- Rebalancing risk
Mutual fund investments are rebalanced frequently by the fund managers and are closely monitored. However, regular reinvestments are often accompanied by the risk of losing out on growth opportunities in their investments.
Though risks associated with mutual funds are many, one can mitigate the same by planning their investments smartly.
Tips to Combat Risks Associated with Mutual Funds
By following these tips, one can effectively cushion the impact of mutual fund risks.
- Build a portfolio that matches your risk appetite
One of the best ways to cushion the most risks associated with mutual funds is by investing in a profile that matches investors’ risk-taking capability. Factors like one’s age, financial standing, risk appetite and financial goals must be weighed in before selecting a specific mutual fund scheme. For instance, individuals with a low-risk appetite and a long-term financial goal will find a balanced portfolio with a profitable mix of both debt and equity suitable.
- Invest through Systematic Investment Plan
Through this investment route, investors will be able to distribute the risk burden significantly. Also, with the help of features like rupee cost averaging and the power of compounding, investors can lower their cost of investment successfully.
- Invest through STP
This investment route also helps to distribute the risk associated with mutual fund investments over a period and also helps to lower the average cost of investment. Collectively, it helps to combat the impact of entering into an overvalued market. The fact it enables investors to shift from one fund to another helps to consolidate gains and lower associated risks successfully.
- Diversify your portfolio
Allocate investments across asset classes and sectors like debt, cash equivalent, equities, etc. to balance the portfolio’s risk-reward ratio and associated market risks effectively. By factoring in risk appetite, time horizon and financial goals, investors can diversify their portfolio accordingly.
For instance, for meeting short-term goals, investors should put their money into debt schemes for capital protection and assured returns. Alternatively, for long-term goals, investors may find equity mutual funds more proficient because of its high risk-reward factor.
Risks in Mutual Funds and Suitable Solutions
This table below highlights some common types of risks in mutual funds and ways to mitigate them in a nutshell.
|Types of Risks||Mitigation Tip|
|Volatility risk||Selecting a diversified portfolio comprising funds schemes with low to moderate risks will help tackle market volatility.|
|Credit risk||Invest in high credit-rated securities with a track of paying substantial and timely interest.|
|Liquidity risk||Investing in a diversified portfolio which comprises funds schemes with moderate to high liquidity will prove useful—for instance, liquidity funds.|
|Concentrated risk||Instead of investing in one asset class or investment sector, investors can put their money into diverse asset classes and sectors.|
|Inflation risk||Parking money into schemes like stock mutual funds, which extend risk-adjusted returns, will help combat inflationary effects.|
Hence, it can be said that there will always be some risks associated with mutual funds. Nonetheless, investors can mitigate the influence of the same and prevent their capital from eroding by adopting smart investment techniques.